Europe's asset-management industry is immensely profitable and larger than ever. But while its long-term growth prospects remain healthy, the financial-market setback that started in mid-2007 will probably dent its fortunes in the short term. Given the industry's inflexible cost structures, its heavy dependence on capital market performance, and early signs that investors may switch to cash or other low-risk alternatives, its 2008 profits could be dramatically lower.

A new McKinsey survey, based on interviews and data collected in early to mid-2007, finds that in 2006, the latest year for which data are available, total assets exceeded €10 trillion for the first time and that total profits surpassed the record set in 2000, at the height of the dot-com boom. Still, the intake of new money (as opposed to gains from market appreciation) rose more slowly than it did in previous years, and costs climbed at a faster pace than assets, eradicating the cost improvements of 2005.

Since 1998, McKinsey has surveyed European asset managers to measure the pulse of their cyclical industry. This time we questioned managers at 118 companies that together hold €6.5 trillion of assets under management for a mix of retail and institutional investors. Collectively, our respondents represent fully 65 percent of the European assets managed on behalf of third parties.¹

In 2006, we found, total assets and the intake of new money rose, but at significantly lower rates than in previous years. Total assets increased by 12 percent, compared with 18 percent in 2005. Asset inflows were weak in major economies such as Switzerland and the United Kingdom, while Italy continued to suffer significant outflows. Market performance accounted for two-thirds of total asset growth in 2006; net inflows, which were responsible for the rest of it, rose by only 4 percent over 2005—the lowest rate of increase since 2002.

Institutional growth has consistently outpaced retail growth during the past few years, and 2006 was no exception. The increase of total assets under management from institutional business accounted for €6.6 trillion of total asset growth, up by 14 percent from 2005. Even so, the increase in institutional assets under management, though strong, was slower in 2006 than it had been during the previous year, which saw growth of about 20 percent. Retail business brought in €3.4 trillion—an 8 percent increase—in 2006, but the rate of growth receded in retail assets as well (Exhibit 1).

Lackluster growth was not the norm everywhere, though. A surge of new money under management and market appreciation spurred significant growth in Eastern Europe, where total assets rose by 39 percent, jumping from €92 billion in 2005 to about €129 billion in 2006, more as a result of inflows than of market performance (Exhibit 2). Traditional products, such as funds of funds and simple capital-guaranteed funds, drove most of the growth in the region. In our view, offerings already well established in Western Europe—such as absolute-return products or small- or midcap funds—will most likely fuel the next growth wave in Eastern Europe.

Even in Western Europe, some players consistently outperform their peers and manage to grow at rates considerably above the market average. In the future, though, winners there may have to develop more solutions-oriented offerings—for example, products that guarantee specific outcomes, asset allocation products, and fiduciary-management services.

In Europe as a whole, costs are rising faster than assets—a particular cause for concern in the current uncertain times. Despite asset management's typically high proportion of fixed costs (IT and the middle and back offices), an increase in cost margins² all but eradicated the substantial improvements made in controlling expenses during 2005. In fact, cost margins, at nearly 19 basis points, were more than 10 percent higher in 2006 than in 2000 (Exhibit 3).

Still, the shift of retail investors out of low-margin, fixed-income products boosted revenue margins³ and, together with increased fees on the institutional side, more than offset rising cost margins. Total profits in 2006 jumped almost 20 percent, to €16 billion.

Although asset management continues to enjoy the sort of economics other industries must envy, our survey findings highlight the risks it faces. With cost margins nibbling away at potential profits, many players could be caught with largely inflexible cost structures at a time when many observers expect that the recent market setback will intensify and turn into a recession in the United States and, potentially, the rest of the developed world. In such a scenario, profits could fall by as much as 30 percent in 2008. Considering that two-thirds of all asset growth in 2006 stemmed from bullish market performance, asset managers should think carefully about how they can best protect their core business while instilling enough flexibility to scale their operations down or up as the economy ebbs and flows.

To lower costs, companies could take advantage of the growing maturity of middle- and back-office outsourcing providers. Players operating within a larger financial-services group could avail themselves of the securities-trading function of its other business units, such as private or investment banking. Asset managers should also exercise discipline about further expansion—for example, by using detailed performance metrics for products and client segments to assess new investments. Recent setbacks in this notoriously cyclical industry will separate the wheat from the chaff, and only the well prepared will surge ahead.