As a largely small-cap investor, I have been a long-term fan of asset management stocks.

I have been attracted to this subsector (within Other Financials) for a number of reasons:

  1. Asset managers tend to have high profitability, thanks to their relatively low capex needs, high operational leverage and huge potential for economies of scale. As a result of this structurally high profitability, free cash flow tends to be high as does Return on Invested Capital. Overall then, a relatively high quality subsector.
  2. Equity-focused fund managers give a relatively high-quality way to have a leveraged long exposure to bull stock markets, such as the one we have experienced since early 2009. Assets under management (AUM) generally benefit from a double whammy in bull markets; the AUM is boosted by positive stock market performance, and retail investors tend to invest more in equity unit trusts when stock markets are rising. 
  3. Merger & acquisition activity can lead to sharp rallies in share price, given that this sector has been rapidly consolidating over the last few years, in an effort to benefit even more from economies of scale. 
  4. Given that this subsector generally generates high levels of free cash flow (and has low investment needs), high dividend payouts and substantial dividend growth are also features of successful fund management groups.

This has led me to invest in the likes of Miton (LON:MGR), Polar Capital Holdings (LON:POLR), Premier Asset Management (LON:PAM) and Record (LON:REC) in the past (I am still invested to some extent in the first two currently).

BUT...

I am becoming concerned about a number of potential headwinds for this sector, after a number of very profitable years.

  1. We could be due for a global stock market correction in the near-term, given the stellar performance particularly of the US stock market last year and this month. This would undoubtedly not be good for high-beta stocks like asset managers.
  2. MIFID II costs on trading, research and investor information will likely weigh on the profitability of smaller fund managers in particular (as they have themselves pointed out in prior statements), and seem to favour the largest fund managers like the US-listed Blackrock, who can more easily absorb these extra administrative costs. 
  3. There can also be considerable…

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