This year is set to be a potentially transformative one for the investment management industry, particularly if markets fail to rebound sufficiently to relieve some of the intense margin pressure many managers, particularly the ‘squeezed middle’, are under. Add in the uncertain impact of regulatory change and the emergence of new technologies, and executive teams are likely to face a significantly above average number of strategic decisions in 2024.
Artificial intelligence (AI) has forced its way into the heart of every IT strategy. Firms are grappling with how to effectively use AI to create and improve business performance, while governments and regulators are contending with how (and how much) to regulate it. Using AI responsibly and ethically will be a critical consideration in how it's employed, and the scale of downside risk, should an AI be badly designed or targeted, is enough to require most firms to build a governance framework around its use.
AI is already showing the ability to improve data analysis, portfolio optimisation and risk management within firms. AI can also transform customer interactions, but successful real-world implementations are still few and far between. The most successful organisations will be those that combine the courage and ambition to be an early adopter with the governance and risk management disciplines to avoid catastrophic mistakes.
Like almost all new technologies, the majority of firms are operating a ‘wait and see’ approach (often combined with a nervous strand of ‘fear of missing out’). Whether ‘wait and see’ is the right call or not is hard to predict; it is typically one way of avoiding the mistakes of the first movers. What's more certain is that there'll be a major gap for any organisation that is slow to follow the successful lead of others. ‘Wait and see’ will need to look more like ‘fast follow’ than for other, less agile, technology advances.
Another emerging topic that still remains highly relevant in 2024 is the parallel development of cryptocurrency as an asset class and the tokenisation of assets and funds to enable far more efficient settlement operations.
The arrival of cryptocurrency as a mainstream asset class has not been a smooth journey. The crunch of the FTX crypto exchange collapsing in late 2022 has somehow been followed, just over a year later, by the Securities and Exchange Commission (SEC) approval of listed exchange-traded funds (ETFs) tracking Bitcoin.
Tokenisation is a slower burn challenge for most firms. In order to realise the opportunity to simplify and save money in settlement systems that tokenisation offers, country legal and regulatory rules will need to be rewritten – and most current law and regulation is (at best) written for the era of the fax machine. Every country, including the UK, has ambitions to modernise its laws to enable tokenisation, some are slightly further ahead than others. This area should be kept under close watch, and dialogues maintained with custodians and administrators as well as trade bodies, so the opportunities present can be pursued in a tangible manner as soon as the legal door is opened to do so.
With Consumer Duty finally coming into effect last year, the principles-based requirement to deliver good outcomes (and avoid foreseeable harms) for consumers has necessitated changes in a range of internal processes in order to demonstrate compliance. For most investment managers, 2024 will feature a continuing need to develop better management information and outcomes testing in order to evidence more effectively that the Consumer Duty is being met – requiring a not insignificant investment in time and effort for most firms.
More disruptive, however, is the emerging reality of the Financial Conduct Authority (FCA) challenging whether legacy fee models represent ‘fair value’. Falling most heavily on wealth managers, due to their retail footprint, the FCA is making it clear on both an industry and firm-by-firm basis that traditional basis points per assets under management (bps per AUM) pricing needs to be justified as fair value. This is inherently a hard ask when the fee being paid varies on the rise and fall of asset values and not due solely to changes in the actual service being provided. Other fee practices under fire include exit charges, and the sharing in returns on client cash deposits which many investment platforms undertake. Taken collectively, it's clear that any fee not aligned with the actual service being provided is at risk of regulatory challenge.
In the run up to the Consumer Duty live date, there was much uncertainty over how the new requirements might impact the fees and prices investment managers could charge. Several months on, it seems safe to conclude that not only will it have an impact, but that the impact will be significant.
If 2022 was a year of extreme market volatility, with the tail-end impact on supply chains of global lockdown policy and global conflicts, 2023 can fairly be described as a year of drift with economic growth slowing amid high interest rates, and pockets of volatility sufficient to keep the hedge funds happy. At least initially, 2024 is unlikely to reverse this, although there are definite signs that this may change by the end of the year.
The major influences on markets are the potential for a strong direction of travel to lower interest rates, potentially by late 2024, and the impact of global politics. Many large economies will experience an election this year, including the US and India, and several European countries. With few exceptions these elections are, at this stage, unpredictable, either due to the outcome being in the balance, or that an almost certain change of government will follow, and the new incumbents will represent a somewhat unknown quantity.
It's hard not to conclude that the second half of 2024 will see more severe market movements than was the case in 2023. As ever, when markets move, investment performance is dramatically affected and the managers who call these movements correctly will register materially better performance than those who don’t. The winners and losers from these events will enter 2025 in very different conditions: the winners with higher income cushioning the price pressures they would otherwise be experiencing, and the losers facing the need to cut costs (or grow new areas of income) more urgently than ever.
Sustainable investment in 2024 is a tale of two trends, both of which are hard to navigate. The first is the changing face of regulatory disclosures that apply to sustainable funds, for instance the UK’s Sustainability Disclosure Requirements. These disclosure requirements – wrapped up in the general principle that ‘greenwashing’ should be prevented – are forcing managers to assess whether it's feasible for their funds to meet the labelling requirements. For funds that don’t meet the requirements, managers must decide whether they should be changed to comply or to forge ahead without a label (and without references to sustainability in its name or marketing). Add in the differences in the sustainability labelling schemes between the UK, the EU and the US, and the feasibility of managing sustainable funds on to a global standard operating model is severely challenged.
The second trend, equally challenging, involves the headwinds being faced by sustainable investment strategies: performance has often been poor in 2023 and client outflows have been high. The question has always been whether the desire of investors to do good would act as a cushion if and when sustainable investments performed poorly. The evidence of 2023 suggests the cushion, if it exists, is not representative of a new paradigm – much client money will choose investment performance over sustainability goals. Investment performance will change, of course, and sustainable investing is likely to enjoy improved performance at some point.
Reasons for optimism can also be drawn from the positions of many governments, who are keen to encourage (or even force) sustainable investment strategies. Although even there, the political pressure being exerted by, for instance, many US states will differ markedly from a state within the EU. Wishing to navigate the fragmented political environment has encouraged many investment managers to take a more nuanced approach to sustainable investments – offering it to clients who seek it, not imposing it on clients that do not – and we expect this trend to continue.
Market consolidation in the investment management sector will also continue in 2024. This is being driven by ongoing margin pressures, large banks looking to refresh their investment management business, and private equity investors buying into the sector. The pace of deals slowed down somewhat last year as buyers reassessed the long-term outlook for the sector, but we expect this to pick up in 2024.
Aside from the globally significant players, all other investment management houses are subject to potential consolidation activity. Some managers are trying to grow their way out of the consolidation trap by pursuing a vertical integration model, adding other parts of the investment distribution chain to their groups as a way of gaining a greater share of value. Others are looking hard at new asset classes: the widespread push into managing private assets (where higher fees can be charged) is the most obvious example of this trend.
Mergers are difficult so it is essential to create post-merger synergies that unlock cost savings, build greater profits and realise growth opportunities. These factors are at the heart of most deals. The better deals also include a focus on improving the customer experience, bearing in mind the new Consumer Duty rules.
The opportunity of new asset classes to generate fees brings with it the upfront cost of building new capability and the significant risk of undertaking unfamiliar activities in an unsafe way. It's reasonable to predict that not every firm that follows the strategy of broadening its menu of asset classes will succeed, one likely outcome of which will be further consolidation.
For more insight and guidance, contact David Morrey.
