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According to BlackRock vice chair Bob Doll, "as many as half of the world's asset managers are breaking even at best".

This week's Economist take an interesting look at the asset management industry, in light of the BlackRock acquisition of Barclays Global Investors. According to the article, more banks are expected to put their asset management divisions on the block, as revenues shrink and profits get squeezed.

It wasn't supposed to be this way. Unlike market-sensitive businesses like proprietary trading and investment banking, the asset management business was a safe business with a predictable fee-based revenue stream. That led to many acquisitions of asset management firms in the past ten years. But the past year has brought challenges, while some of the anticipated cost savings from scale have failed to materialize.

I would guess that a lot of the margin erosion is simply due to firms' expanding their cost structures during the boom years. With assets under management growing each year from a combination of investment growth and new contributions to 401(k) funds, it's easy to see how many firms became less efficient. At the same time, while marketing directly to institutions is fairly inexpensive, marketing your services to a retail audience can become costly.

The article also points out one of the structural challenges facing the industry that should have been apparent all along: the fund management industry doesn't scale as well as other businesses. The most lucrative side of the business has always been active management, where fees can range from 60 to 150 basis points or more. Indexed management fees are much lower - typically 20-30 basis points. But it's almost impossible for active managers to consistently beat the market as they grow. As funds grow, it's inevitable that their holdings make them more and more like the major indices. They can't possibly take large enough positions in small caps to impact performance as they grow.

Where will the industry go from here? While giant firms like the newly re-Christened BlackRock Global Investors, T. Rowe Price, Fidelity and Vanguard will surely continue to grow, we may see the active management sector again become decentralized with smaller, independent firms handling much of the load. Private equity firms like TA Associates can take a stake in multiple smaller managers without impacting their ability to invest in small caps. But it may be a while before we see strong growth and profitability in this sector.