PROFESSIONAL, active investors have been increasingly attracting unwanted attention for their inability to beat the wider market. What tends to generate less discussion are the consequences this crisis of confidence in active fund management will have for the businesses they work for.

Greg Johnson, the chief executive and chairman of Franklin Resources, told the Financial Times last Thursday that he predicted a wave of consolidation in the industry, admitting that passive funds were eroding profit margins. His admission - unusual in its candour - was grounded in the simple laws of business that are taking a brutal toll on some of the once-mighty names in investment management.

Requiring little start-up capital and generating high profit margins, the traditional long-only fund manager for many years generated attractive returns for shareholders. Facing large outflows and falling margins some of the better-known, medium-sized, long-only fund houses are now at risk of disappearing unless they can find a way of differentiating their business from a distinctly uninspiring pack.

The question for anyone looking to buy is what are these businesses, and the assets they currently manage, actually worth?

Global assets under management at traditional investment houses have grown at a compounded annual rate of 5.4pc between 2005 and 2013 to sit at $63tr, according to research by McKinsey. This sounds like a large number that should signal a healthy industry. The true picture for the industry’s mid-market players is far grimmer.

The same McKinsey report estimates ‘traditional’ funds have haemorrhaged revenue share to alternative investment managers, such as hedge funds.

Alternative managers in 2013 generated a third of total industry revenues from only 12pc of the total asset base. By 2020, McKinsey expects alternative managers’ share of assets to rise to just 15pc of the global industry total, but to produce up to 40pc of revenues.

Much like the largest operators in the British supermarket sector the ‘midmarket’ fund house had achieved a dominant market position and was able to take advantage of economies of scale and distribution networks to draw in a relatively captive customer base. However, like supermarkets, the rise of low-cost competitors - in this case passive index trackers and exchange traded funds - has irreversibly altered the economics of the industry.

British supermarkets have watched their profit margins for basic goods eroded by low cost competitors. At the same time consumer tastes have split between these low-cost outlets and higher quality, more expensive stores.

Low-cost, low-margin passive funds in this analogy take the role of the discount retailers such as Lidl. Much like a shopper looking for the cheapest loaf of bread, investors seeking cheap market exposure, or ‘beta’, now know where to go. They increasingly see little need to pay extra for active managers who in better years track the wider market and in worse ones underperform it.

Lastly come the hedge funds, which have managed to maintain or grow their market shares in spite of their cost by convincing clients they are a luxury service unavailable elsewhere. If they were a British supermarket, they would be Waitrose, or at a stretch Harrods.

Mr Johnson has recognised a need for radical action, but the remedies are far from clear. It is an open secret many asset managers are open to a deal, and some have even actively hired bankers to hawk themselves to rivals. One senior executive at one of the world’s largest asset managers recently admitted the old model is broken, and that large job losses and painful mergers are needed to survive.

The question for anyone looking to buy is what are these businesses, and the assets they currently manage, actually worth? While many still have brands that are respected by their clients these will not be enough to save them.

Many asset management executives have long been wary of paying up for rivals. What can appear to be a large pool of assets earning fees can quickly turn to mush as clients redeem their money, leaving an acquisition worthless.

This means the only solution for those on the block will be to prove the value of their business by generating strong investment performance, proving ‘midmarket’ asset management still has a place in the world. Failure to do so can only end in their eventual extinction.

miles.johnson@ft.com

Published in Dawn, Business & Finance weekly, June 13th, 2016