HEADACHES MOUNT FOR ASSET MANAGERS

We recently moved to a more cautious stance given a few near-to-medium-term headwinds

It wouldn’t be much of a surprise to hear that Canada’s largest independent asset managers are feeling a bit vulnerable these days. Whether it’s forthcoming regulatory changes, growing competition from exchangetraded funds or the steady pilfering of market share by the country’s biggest banks and life insurers, asset managers have been battling one headache after another over the past year.

As a result, they’ve struggled at times to keep up with other publicly traded companies during the current bull market run in stocks. But to their credit, some — certainly not all — of them have done a good job of defying the odds stacking up against them by finding ways to maintain and expand their client base as healthy equity markets drive favourable asset growth across the industry.

Unfortunately, the adversity from growing competition and more onerous regulations remains undiminished heading into another earnings season next week. As a whole, the group, which runs the gamut from mutual fund giants such as CI Financial Corp. and AGF Management Ltd. to more boutique firms like Gluskin Sheff + Associates Inc., is expected to remain a segment of the Canadian equity market that is under fire in the months ahead.

“We recently moved to a more cautious stance given a few near-tomedium-term headwinds,” said Gary Ho, analyst at Desjardins Securities in a recent note, summarizing the myriad challenges facing the industry.

At the top of Ho’s list is the uncertainty around new disclosure rules, which are being phased in by securities regulators. Called Client Relationship Model 2 (CRM2), the rules will eventually require advisers and asset managers to provide greater transparency about the fees and performance of their products.

Investors in general will no doubt applaud a potential ban or unbundling of embedded trailer fees, but those investing in asset managers remain anxious about such a prospect after regulators recently postponed a report meant to address the matter by at least another year.

“This delay will cast an overhang over the near term,” Ho said.

“We continue to believe that firms that have scale, own distribution and are ahead of the curve on preparing advisers/clients for regulatory changes will be winners.”

Underlying these regulatory risks is the fact that fund fees are already in decline across the industry.

Management expense ratios dropped to 200 basis points in 2014 from 206 basis points in 2013 and, on average, are 24 basis points lower than they were a decade ago, according to Investor Economics.

Ho said part of the decline can be chalked up to a shift toward lower-fee fixed-income funds on behalf of investors. But firms are also selectively adjusting pricing on certain products to remain competitive against lower-cost alternatives such as ETFs, which have increased their market share to seven per cent from two per cent since 2004.

Canada’s biggest banks and life insurance companies are also a rising threat. The banks accounted for 46 per cent of mutual fund assets in Canada compared to 40 per cent by independent asset managers and five per cent by lifecos at the end of February, but Ho expects the banks’ market share to hit as high as 65 per cent over the medium- to long-term while the lifecos increase their share to 15 per cent.

Combined, these headwinds paint a sobering future for the independents and their investors.

Ho’s underweight stance for the sector reflects this, but that doesn’t mean upside opportunities do not exist.

All five of the firms he covers (CI, Gluskin Sheff, IGM Financial Inc., Sprott Inc. and AGF) are expected to provide some degree of positive return over the next 12 months. Gluskin Sheff, one of his two top picks, is estimated to rise 20 per cent, while CI Financial Corp., his other top pick, is forecast to climb 18 per cent.

“We believe CI is ahead of the curve in tackling the looming regulatory changes, particularly in educating advisers, communicating with clients and investing in people and technology, and the company has a scale advantage over peers,” Ho said.

John Aiken, a Barclays Capital Markets analyst, is also relatively bullish on CI, the country’s largest independent asset manager.

Assisted by strong net sales during the recent RRSP season, he expects the company to post sequential earnings growth of 4.2 per cent and increase its dividend by five per cent when it reports first-quarter earnings results on May 7.

By comparison, Aiken expects IGM Financial to book earnings growth of 2.4 per cent over the previous quarter, and keep its dividend unchanged.

“While AUM growth was strong in the quarter, we remain cautious on our outlook for domestic economic growth and believe that boosts from positive investment performance will be skewed toward asset managers with greater exposure to U.S. and international equities,” he said in a recent note.

“Against this backdrop, we believe that given its efficient operations and relatively stronger AUM and net sales performance, CI’s earnings and dividend growth should continue to outpace its peers, and it remains our favourite name among the asset managers.”

Most analysts agree that CI is a better bet than IGM and AGF, its two nearest rivals, but some believe better opportunities lie with the smaller players in the group such as Gluskin Sheff and Fiera Capital Corp.

“Fiera remains well positioned to drive superior asset growth on the back of its access to bank-owned distribution, its U.S. platform, solid fund performance and additional acquisitions such as Samson Capital Advisors,” said Shubha Khan, analyst at National Bank Financial in a note to clients.

“We believe Gluskin Sheff will benefit from the solid improvement in net sales over the past 12 months, reduced pressure on the average fee rate as AUM gradually shifts to higher-fee funds/ strategies, and improved investment performance and operating leverage.”

Ultimately, Canada’s independents may grind higher in the year ahead, but with competitive pressures mounting and the regulatory environment uncertain, returns from the group won’t come easy.