Improving Equity and Credit Markets Have Lifted T. Rowe Price's AUM, but Headwinds Persist

Strategist

Greggory Warren

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In an environment where active fund managers are under assault for poor relative performance and high fees, we believe wide-moat T. Rowe Price is one of the best positioned U.S.-based active asset managers we cover. The biggest differentiators for the firm are the size and scale of its operations, the strength of its brands, its consistent record of active fund outperformance, and reasonable fees. T. Rowe Price also has a stickier set of clients than its peers, with two thirds of its assets under management derived from retirement-based accounts.

At the end of December 2023, 55%, 57%, and 86% of the company's mutual fund AUM were beating their Morningstar category median on a three-, five-, and 10-year basis, respectively, with around 60% of funds holding an overall rating of 4 or 5 stars, better than just about every U.S.-based asset manager we cover. T. Rowe Price also has a much stronger Morningstar Success Ratio—which rates a firm's ability to deliver consistent, peer-beating returns over longer periods—than its publicly traded peers, giving it an additional leg up, in our view.

While the company will face headwinds in the near to medium term as baby boomer rollovers continue to affect organic growth in the defined-contribution channel, we think the firm and defined-contribution plans in general have a compelling cost and service argument to make to pending retirees, which should mitigate some of the impact. We also believe T. Rowe Price is uniquely positioned among the firms we cover (as well as the broader universe of active asset managers) to pick up business in the retail-advised channel, given the solid long-term performance of its funds and reasonableness of its fees. 

That said, the company is not immune to the pressures caused by the growth of low-cost passively managed products. With total and average AUM expected to increase at a low- to mid-single-digit rate on average annually during 2024-28, and management fees pressured by ongoing industry dynamics, we envision T. Rowe Price generating a negative 1.7% CAGR for revenue, with adjusted operating margins in a 31%-37% range over our five-year projection period.

Business Strategy & Outlook

We believe the asset-management business can be conducive to the creation of economic moats, with switching costs and intangible assets being the most durable sources of competitive advantage for firms in the industry. Although the switching costs might not be explicitly large, inertia and the uncertainty of achieving better results by moving from one asset manager to another tend to keep investors in the same funds for extended periods. As a result, money that flows into asset-management firms tends to stay there. For the industry overall, the average narrow redemption (retention) rate, which does not include exchange redemptions, has been 25% or less (75% or greater) annually the past 5-, 10-, 15-, 20-, 25-, and 30-year time frames. Including exchange redemptions, the rate has been less than 30% (greater than 70%). Firms offering niche products with significantly higher switching costs—like retirement accounts, funds with lockup periods, and tax-managed strategies—have tended to hold on to assets longer.

Because T. Rowe Price does not break out its net flows (which are gross sales less investor redemptions) we assume, based on its historical record of organic AUM growth, that the company's average annual redemption rate has been at its worst no worse than the industrywide rate, especially given the tailwinds that have been provided at times by defined contribution plans the past couple of decades. That said, redemptions have outpaced flows into 401(k) plans since the baby boomer retirement phase started in 2011, impacting the company's organic AUM growth. During the past five (10) calendar years, T. Rowe Price's organic AUM growth rate averaged negative 2.1% (negative 0.8%) with a standard deviation of 3.2% (2.6%), which meant that in most years the firm was not fully compensating for investor redemptions with new flows into its products. 

In future, we expect T. Rowe Price to generate negative 1.2% (negative 0.5%) average annual organic AUM growth during 2024-28 (2024-33), with a standard deviation of 2.2% (2.7%), driven by ongoing investments in retail distribution, enhanced products, and technology, as well as the company's move into alternative assets. T. Rowe Price will continue to have a slightly better-than-average switching cost profile relative to its active asset manager peers despite continuing to see redemption rates at or above the industry average due to the continuation of the baby boomer retirement cycle, as well as the growth of passively managed target-date funds. We continue to believe that flows should improve after 2026, when fewer baby boomers are expected to retire and millennials start hitting their peak earnings years, with our 2029-33 forecast calling for positive 2.3% average annual organic AUM growth with a standard deviation of 1.6%.

In our view, traditional asset managers like T. Rowe Price can improve on the switching cost advantage inherent in the business with organizational attributes (such as product mix, distribution channel concentration, and geographic reach) and intangible assets (such as strong and respected brands and manager reputations derived from successful and repeatable investment performance) that can provide them with a degree of differentiation from their peers. While the barriers to entry are not all that significant for the industry, the barriers to success are extremely high—as it takes time and skill to not only put together a long enough record of investment performance to start gathering assets but to build the scale necessary to be competitive. This has meant the larger, more established asset managers in the industry have tended to have an advantage over smaller players, especially when it comes to gaining cost-effective access to distribution platforms. That said, we do not think the cost advantage applies to the traditional asset managers—expect in the case of index fund and ETF providers—as scale does not always confer better than average operating profitability and the industry tends to behave as an oligopoly when it comes to pricing. 

Competition for investor flows can be stiff and has traditionally centered on investment performance. Although institutional investors and retail gatekeepers are exerting pressure on pricing, competition based on price has been rare, aside from what we've seen in the U.S. market for exchange-traded funds. While compensation remains the single-largest expense for most traditional asset managers, supplier power has been manageable as many firms have reduced their reliance on star managers and have tied manager and analyst pay to both portfolio and overall firm performance. Asset stickiness (the degree to which assets remain with a manager over time) tends to be a differentiator between wide- and narrow-moat firms, as asset managers that have demonstrated an ability to gather and retain investor assets during different market cycles have tended to produce more stable levels of profitability, with returns exceeding their cost of capital for longer periods. While the more broadly diversified asset managers are structurally set up to hold on to assets regardless of market conditions, it has been firms with solid product sets across asset classes (built on repeatable investment processes), charging reasonable fees, and with singular corporate cultures dedicated to a common purpose that have done a better job of gathering and retaining assets.

T. Rowe Price, in our view, has a wide economic moat. We think the company's size and scale, the strength of its brands, and its above-average record of active fund outperformance has provided the firm with a leg up over competitors. While the firm's product mix is not overly diverse, with 52% of its $1.450 trillion in AUM at the end of January 2024 dedicated to equity strategies, 33% in multiasset offerings (comprised primarily of its target-date fund series, which accounted for 28% of total AUM), 12% in fixed-income and money market funds, and 3% in alternatives (comprised entirely of its stake in Oak Hill Advisors), the company derives a significant portion (just over two thirds) of its AUM from defined contribution retirement assets and deferred annuity and direct retail retirement assets. With the switching costs for these offerings being significantly higher than those for most other accounts (the majority of which are non-tax-deferred), T. Rowe Price has had a stickier set of assets than its peers. Benefiting from a steady stream of investor inflows into defined contributions and other retirement plans, the firm has rarely seen outflows historically. However, the company has experienced a prolonged period of outflows the past five years as it has felt the brunt of the baby boomer retirement phase, an easing of restrictions on loans and distributions from the Coronavirus Aid, Relief, and Economic Security Act in response to the COVID-19 pandemic, and the selloff in growth equities during 2022-23. 

That said, the firm's cost-conscious culture and stable AUM and revenue levels have allowed it to consistently generate adjusted operating margins in excess of the industry average of 36%. T. Rowe Price's ability to generate more stable revenue, profitability, and cash flows than its peers has provided the company with excess capital that could be used to build on the competitive advantages it already possesses. T. Rowe Price has been effective managing its scale, with adjusted operating margins of 42.8% (42.9%) on average during 2019-23 (2014-23), allowing it to generate an estimated $2.3 billion ($1.9 billion) in annual free cash flow (defined as cash flow from operations less capital expenditures) on average, with adjusted ROICs exceeding 35% (and ROICs with goodwill included exceeding 20%). 

T. Rowe Price has withstood many of the headwinds facing active managers with its rigorous research process, generally solid performance across asset classes, and continued investment in its research team. With solid three- and five-year relative investment performance generated consistently, tending to be an important benchmark for the gatekeepers of retail-advised and institutional platforms, T. Rowe Price has historically held its own, despite only having 52%, 56%, and 71% of the firm's sponsored U.S. mutual funds beating the Morningstar category median on a three-, five-, and 10-year basis, respectively, at the end of December 2023. When compared with fee-charging passive funds, which is a higher hurdle than active peers, T. Rowe Price comes off a bit worse of late with just 48%, 56%, and 53% of its sponsored U.S. mutual funds beating peers on a three-, five-, and 10-year basis at the end of last year. While these are still solid results when compared with other U.S.-based traditional active fund managers, it is uncharacteristic for a firm that has consistently been in the upper quartile on a performance basis with its fund offerings.

Much of the success T. Rowe Price has had historically has been built on the firm having a single corporate culture dedicated to a common purpose, which has been reflected in the level of its investment performance, the rate of organic growth the company has been able to generate, and the relatively small amount of employee turnover through the years. Morningstar views the management team at T. Rowe Price as being highly insular and very protective of the culture that the firm has built—one that has cultivated a disciplined, risk-conscious investment process that has consistently produced successful results across its fund lineup, often with less volatility than peers. As part of ongoing efforts to enhance the company's competitive positioning, management has been willing to evolve, though, focusing for much of the past several years on building additional scale through new investment products, expanding the reach of its investment advisory business by further penetrating domestic distribution channels (like the retail-advised channel) and moving into non-U.S. markets (especially emerging and developing economies in the Asia-Pacific region), and bolstering technology in an effort to improve performance outcomes, drive down incremental costs, and improve product distribution. 

That said, the company's heft has made it tougher for its equity strategies to build up positions in small- and mid-cap stocks without pushing against firm-level ownership limitations. To address this challenge, T. Rowe Price split into two distinct research entities in March 2022, with six strategies, including five capacity-constrained equity strategies, moving to the new division, T. Rowe Price Investment Management, while the rest of the firm exists as T. Rowe Price Associates. This highlights the firm's willingness to maintain  investment focus while also recognizing that the business must evolve to flourish in an industry that continues to gravitate toward passive investing. T. Rowe Price receives some of the highest marks for corporate culture among the U.S.-based asset managers we cover, owing not only to its ability to produce repeatable investment strategies but to prudently adapt to the changing competitive landscape all while attracting and retaining quality investment talent and remaining a trustworthy steward of capital. We continue to believe T. Rowe Price is well positioned to navigate the headwinds the U.S.-based asset managers will face in the next decade and expect it to be one of the rare positive organic AUM growth generators in the group.

Wide

Economic Moat

T. Rowe Price Group

T. Rowe Price Group, Inc. is a global investment management organization, which engages in the provision of investment management services. The firm provides an array of mutual funds, sub advisory services, and separate account management for individual and institutional investors, retirement plans, and financial intermediaries. It also offers investment planning and guidance tools. The company was founded by Thomas Rowe Price Jr. in 1937 and is headquartered in Baltimore, MD.

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Earnings data Q1 2024

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T. Rowe Price Group, Inc. engages in the provision of investment management services. The company was founded by Thomas Rowe Price Jr. in 1937 and is headquartered in Baltimore, MD.

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