Morningstar has downgraded Magellan Financial Group (MFG) in light of unforeseen management disruptions and underperformance.

“Our prior thesis has not played out,” acknowledges Morningstar analyst Shaun Ler in his latest note. Ler had expected Magellan to perform and clients to remain with the fund manager even during periods of underperformance.

“We underestimated the market disruption to Magellan’s investment style, and performance has not materially improved since it began in late 2020,” Ler said.

“We also understated the downside from the dilution of Magellan’s brand, evidenced by mandate losses and outflows.”

Morningstar has not only cut its fair value for the business but also removed its narrow moat rating. The new no-moat rating reflects the loss of trust in Magellan, which was a key detractor that wasn’t captured in his prior investment case, said Ler. Magellan has struggled to restore investor sentiment after co-founder Hamish Douglass left the business.

“Since the first net outflows (June quarter of 2021) to fiscal 2022’s end, net outflows were close to AUD 50 billion, roughly 50% of Magellan’s starting FUM. This was different to the whole of 2016 and 2017, when there were only two months of net outflows despite Magellan’s performance lagging considerably in 2016.”

“The building blocks that helped fortify Magellan’s moat—like its distribution reach and positive fund ratings—are redundant if its reputation is dented or if it does not deliver satisfactory investment returns,” Ler says.

Ler believes that it will take time for its new portfolio managers to build credibility and for new management to restore its growth.

He now expects funds under management (FUM) to grow at a slower pace to $69 billion, lower than Morningstar’s forecast of $78 billion and a fiscal 2022 base of $61 billion. He also expects net profit to be about $229 million per year through to fiscal 2027, below its five-year average of $377 million.

While he also believes that the new management, led by CEO David George, wants to adapt Magellan to an increasingly competitive landscape, he believes the outlook will remain challenging.

If Magellan is to grow its book with new investor money, it needs to outperform; tackle key person risk, add different products; reclaim its position in model portfolios; and recover its strong fund ratings and reputation.

“These milestones will be challenging and at minimum will take years to achieve.”

Well positioned businesses

It should be noted that it is a challenging market for any asset manager. “Asset managers are more vulnerable to rising interest rates and inflation, compared with more resilient businesses like Wesfarmers (WES). The current market is tough for any standalone asset manager.”

For Ler, there are opportunities for investors in the diversified financial services businesses and his picks include Pinnacle Investment Management Group (PNI) and Challenger (CGF).

“Pinnacle has a diversified business. In the last fiscal year, the business still had net inflows compared with many other active managers.”

Its diversified business includes a range of boutique investment managers, or “affiliates”, providing a breadth of asset classes.

According to Ler, the asset class diversity of Pinnacle’s affiliates helped cushion market losses.

In fiscal 2022, aggregate portfolio losses for the business were below 10 per cent, less than the S&P/ASX 300 and MSCI World, which lost 10.4 per cent and 17.1 per cent, respectively.

Ler also noted that more of Pinnacle’s products are being used in the retail market. Its top 20 wealth clients now invest with three or more of its boutique managers. Around 65 per cent of Australia’s financial advisers invest with Pinnacle.

Challenger is also well positioned in market with rising interest rates benefiting its annuity business.

“We expect maturity rates to fall over the medium term, as interest rates stay higher than historically, prompting clients to buy/reinvest into longer-dated products,” Ler says.

In its fiscal 2022 results, Challenger reported that more than 80 per cent of institutional annuities were reinvested, while sales of new two-year (or longer) annuities also grew faster than one year annuities.

Moreover, Challenger has a strong presence in annuities in Australia with its products on platforms that are used by more than 70 per cent of Australia’s financial advisers.