BlackRock’s Equity iShares, Passive Fixed Income Funds Will Remain Primary Revenue Drivers Going Forward

The ongoing trend of institutional funds being pulled from actively-managed funds and channeled into low-cost indexed and ETF alternatives weighed on BlackRock’s (NYSE:BLK) revenues for Q4 2016, resulting in the world’s largest asset manager missing revenue expectations for the quarter. ^[1] Investors expected BlackRock to post record revenues in view of strong market conditions over the last two months of the year, but the outflows from lucrative active funds weighed on the company’s investment advisory fees. Strong performance fees for the quarter mitigated the impact of this on the top line to a large extent, and BlackRock’s continuing focus on reining in costs helped it comfortably beat earnings expectations for the quarter.

As we have pointed out on several occasions over the last few quarters, the price war among ETF incumbents and the trend of strong inflows in low-cost funds at the expense of active funds is expected to intensify once the Department of Labor’s fiduciary rule governing retirement investment advice comes into force later this year. However, the improved outlook for the U.S. economy, and the Fed’s optimistic forecast for interest rates should catalyze growth in BlackRock’s asset base in the near future. As a result, we revised our price estimate for BlackRock’s shares upward from $380 to $394. The new price estimate is slightly ahead of the current market price.

See our full analysis for BlackRock

BlackRock Made The Most Of A Strong Quarter…

The table above summarizes the factors that aided BlackRock’s pre-tax profit figure for Q4 2016 compared to the figures in Q4 2015 and Q3 2016. Although total revenues fell compared to the figure a year ago, the decline was largely due to non-operating income changing from $11 million in Q4 2015 to a loss of $38 million in Q4 2016. The core investment advisory fees – representing the recurring component of BlackRock’s top line – gained year-on-year but fell sequentially as the asset base now has a larger proportion of cheaper iShares and indexed assets compared to actively-managed assets. Notably, there was a sizable increase in performance fees for the quarter compared to Q3 2016 – jumping sequentially from $58 million to $129 million, but below the $169 million figure a year ago. Also, BlackRock’s decision to push its advisory platform (“Aladdin”) to clients continues to add to the top line, as fees from the unit increased from $138 million in Q4 2015 to $156 million now.

Considering the fact that BlackRock’s headcount has remained constant around 13,000 over the three quarters discussed, the marginal changes in compensation expenses can be attributed to changes in performance-linked incentives. At the same time, the year-on-year reduction in operating expenses is an important step in the right direction for the asset management giant. It should be noted that operating expenses are seasonally higher for the last quarter of the year – which explains the increase in this figure quarter-on-quarter. The overall cost discipline led to an increase in BlackRock’s operating margin (adjusted basis) from 41.6% in Q4 2015 to 44.4% in Q4 2016. You can see how changes to BlackRock’s operating margin affects our price estimate by making changes to the chart below.

Equity iShares, Indexed Fixed Income Funds Adding To Line

BlackRock offers a complete range of investment products, including actively-managed as well as passively-managed (indexed) equity and fixed income funds, ETFs (iShares) and multi-class asset funds, in addition to currency, commodities, and other alternative investment funds. The company witnessed mixed inflows for its fund classes in the fourth quarter, with its actively-managed funds (both equity as well as fixed income), and its alternative investment funds reporting outflows for the period. Notably, Q4 2016 was one of the rare occasions in recent years when the company’s fixed income ETF offerings saw net outflows (albeit a small one of $326 million). This was, however, more than made up for by inflows into low cost equity funds, as equity ETFs amassed almost $51 billion in new assets followed by ~$12 billion in inflows for indexed equity funds.

The interest rate hike in early December also fueled the growth of BlackRock’s indexed fixed income funds, which reported inflows of $27 billion. Taken together with almost $18 billion in new assets for money market funds, BlackRock’s net inflows for Q4 2016 were just over $98 billion. The table below captures how BlackRock’s long-term assets under management (AUM) changed year-on-year as well as quarter-on-quarter.

The strong inflows along with improvements in market valuation of securities helped BlackRock grow its total long-term assets to $4.74 trillion by the end of 2016. Taken together with cash management fund assets of over $400 billion, BlackRock’s total assets under management is now at a record $5.15 trillion. Additionally, BlackRock’s equity and fixed income iShares offerings continue to grow in size and now account for almost 25% of all assets, as seen in the chart below.

With Actively Managed Funds Continuing To Shrink

While there has been a fundamental shift in investor preference away from active funds over recent years, the problem has been exacerbated for BlackRock as its funds have performed much worse than the benchmarks they tracked for four consecutive quarters now. Only 60% of the assets in taxable fixed income funds and 64% of those in tax-exempt fixed income funds performed better than the benchmark or peer median over a one-year horizon. These figures are far worse for actively managed equity funds, where more than 50% of them continue to lag benchmarks and peers.

While poor performance by actively-managed funds has hurt fee revenues, they have triggered sizable outflows in funds out of them over recent quarters. Total outflows from active equity funds in Q4 exceeded $4.5 billion – bringing the total outflows from these funds for full-year 2016 to over $20 billion. Now active equity funds demand much higher base fees (roughly 0.6% of assets for BlackRock) compared to indexed equity funds (around 0.05% of assets). And they also attract sizable performance-related fees. We expect these outflows to continue in the near future – negatively impacting BlackRock’s revenues.

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1. Q4 Earnings Release, BlackRock Investor Relations, Jan 13 2017 [↩]