Invesco Ltd. (IVZ) Q2 2017 Earnings Report, Transcript and Summary

This presentation, comments made in the associated conference call today may include forward-looking statements. Forward-looking statements include information concerning future results of our operations, expenses, earnings, liquidity, cash flow and capital expenditures, industry or market condition, AUM, geopolitical events and their potential impact on the company, acquisitions and divestitures, debt and our ability to obtain additional financing or make payments, regulatory developments, demand for and pricing of our products and other aspects of our business or general economic conditions. In addition, words such as believes, expects, anticipates, intends, plans, estimates, projects, forecasts and future conditional verbs such as will, may, could, should and would, as well as any other statement that necessarily depends on future events, are intended to identify forward-looking statements. Forward-looking statements are not guarantees, and they involve risks, uncertainties and assumptions. There can be no assurance that actual results will not differ materially from our expectations. We caution investors not to rely unduly on any forward-looking statements and urge you to carefully consider the risks described in our most recent Form 10-K and subsequent forms 10-Q filed with the SEC. You may obtain these reports from the SEC’s website at www.sec.gov. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns out to be inaccurate.

Welcome to Invesco’s Second Quarter Results Conference Call. [Operator Instructions] Today’s conference is being recorded. If you have any objection, you may disconnect at this time. Now I would like to turn the call over to your speakers for today: Marty Flanagan, President and CEO of Invesco; and Loren Starr, Chief Financial Officer. Mr. Flanagan, you may begin.

Thank you very much, and thank you for joining us today. And I will give the highlights of the business review and Loren will review the financials, as we typically do, and then open it up to everybody’s questions. So let me begin by highlighting the firm’s operating results for the second quarter. I’m on Slide 4 of the presentation, if you’re so inclined to follow us and that is on the website. Long-term investment performance remained strong again during the quarter, ending with 71% and 78% of assets ahead of peers on a 3- and 5-year basis. And the strong performance contributed to solid retail inflows during the quarter, $1.4 billion. Retail inflows were offset by institutional outflows, which resulted in net outflows of $0.6 billion. Now, adjusted operating margin for the quarter was 39.3%, up from 37.7% over the prior quarter and we returned $119 million back to shareholders. Assets under management were $858 billion at the end of the quarter, up from $834 billion in the prior quarter. Adjusted operating income was $357 million for the quarter, up from $327 million in the prior quarter, which resulted in adjusted earnings per share, diluted earnings per share for the quarter of $0.64, up from $0.61 in the prior quarter. And based on continued strong fundamentals of the business, we’re providing a quarterly dividend of $0.29 per share, which represents a 3.6% increase. And before Loren gets to the financials, let me spend a few minutes on investment performance and flows. On Slide 7, you’ll note the performance over 1, 3, 5 and 7 years, and again, our commitment to investment excellence, and the work that the teams have done to build out a very strong culture, continues to generate very strong investment performance across the enterprise. And as I mentioned, 71% of the assets were in the top half on a 3-year basis; and 78% of assets on a 5-year basis. Moving to flows, you’ll note on the active side, gross sales and redemptions were roughly in line with the same quarter in the prior year, but the second quarter did see continued improvement in the positive trends in net active flows, which you’ll note on Slide 8. Flows continue to be strong in taxable fixed income and Core Plus Bond funds. Flows in the passive capabilities were offset for the first quarter, primarily reflecting continued weak demand in our UIT – with UITs and a single large low fee real estate redemption during the quarter. We did see, during the quarter, solid flows into PowerShares fixed income, and the Senior Loan Fund in particular. Retail flows were solid during the quarter, reflecting continued strength in certain of our PowerShares ETFs, as well as Global Targeted Return, European equities and other funds. We also saw strong inflows into our cross-border retail funds in Europe. Our pipeline of won but not funded institutional opportunities remains strong. The funding was slower in the quarter than we anticipated, and redemptions were in line with where they were in the prior quarters, which led to the $2 billion in institutional outflows. The outflows are largely attributed to a slowdown in sales in Asia and heightened redemptions at stable value as clients were changing their asset allocations typically within in the plan. Although the flow fissure was mixed for the second quarter, it’s important to note that the composition of the inflows has been driven towards highly active capabilities and month-to-date, long-term inflows of more than $1.4 billion post June 30, reflecting a strength in our cross-border business in particular. And as always, we’re early into the quarter. It could change, but so far, I think we’re off to a good quarter with regard to flows. So Loren, do you want to...?

Yes, very much, thanks, Marty. So looking at our schedule on total assets under management, we saw quarter-over-quarter, total AUM increase $23.5 billion or 2.8%. That was driven by market gains of $13 billion, positive foreign exchange translation of $8.1 billion, we saw $2.8 billion of inflows into the money market capability. Also $0.2 billion of inflows into the QQQs. But these factors were somewhat offset by long-term net outflows of $0.6 billion. Average AUM for the second quarter came in at $849.2 billion, 2.3% versus the first quarter. And then looking at our net revenue yield, that came in at 42.7 basis points and our net revenue yield, excluding performance fees, was at 41.8 basis points, so that was an increase of 0.9 basis points over the first quarter. The positive impact of foreign exchange and the change in AUM mix added 0.7 basis points. One additional day added 0.4 basis points. These positive factors were then somewhat offset by the impact of a reduction in other revenue, which acted to decrease the yield by 0.2 basis points. Moving on to Slide 12, that provides our U.S. GAAP operating results for the quarter. As usual, my comments today will focus exclusively on the variances related to our non-GAAP adjusted measures, which can be found on Slide 13. Looking at Slide 13, you’ll see our net revenues increased by $39.2 million or 4.5% quarter-over-quarter to $906.3 million, which included a positive foreign exchange effect of $9.1 million. Within that net revenue number, you’ll see that our adjusted investment management fees increased by $54.3 million or 5.6% to $1.03 billion. This reflects higher average AUM as well as an additional day during the second quarter. Foreign exchange increased our adjusted management fee by $10 million. Adjusted services and distribution revenues increased by $4.9 million or 2.4%, reflecting our higher average AUM in the quarter. FX decreased our adjusted service and distribution revenues by $0.1 million. Our adjusted performance fees for the quarter came in at $18 million, and these are earned from a variety of investment capabilities, including $7.4 million from accounts managed by our U.K. team, $6 million came from our private equity business, $2.7 million came from our Asia Pacific investment teams. Foreign exchange increased performance fees by $0.3 million. And in the last two quarters of 2017, I will just update my guidance here, we expect performance fees to decline to roughly $5 million to $7 million per quarter, which, again, is subject to my usual caveat, that forecasting performance fees is an imperfect science, and certainly one that we don’t have a huge line of sight to. The adjusted other revenues in the second quarter came in at $17.3 million, and that was a decrease of $3.5 million from the prior quarter. It was driven by lower real estate transaction fees, UIT revenues as well as other front-end load fees. Foreign exchange increased our adjusted other revenue by $0.1 million. Again, looking to guidance here, looking forward to the second half of 2017, we would expect other revenues to remain near the second quarter levels at $16 million to $17 million per quarter. Moving on down to the third-party distribution, service and advisory expense, which we net against gross revenues, that increased by $16.8 million or 4.8%. That’s consistent with our increased revenues derived from the retail-related AUM as well as the additional day count in the quarter. Foreign exchange adjusted our third-party distribution, service and advisory expenses by $1.2 million. And before I move to the expense area of the P&L, let me try to summarize the revenue guidance I just provided in terms of net revenue yield. So looking at the second half of 2017, we have two offsetting impacts. We would expect to see our net revenue yield, excluding performance fees, increase by roughly 0.5 basis points, and that’s driven primarily by the increase in day count, as well as the asset mix in the second half of the year. This increase, however, is going to be offset by the acquisition of Source assets, which will be dilutive to the firm’s net revenue yield. As we had talked about, that’s about $25 billion, and somewhere between 16 to 17 basis points. As a result, the overall net revenue yield, excluding performance fees, should remain actually fairly consistent with the second quarter level at 42 basis points for the second half of the year. Again, this guidance assumes flat markets and foreign exchange from today’s levels. All right, so let’s move to the expenses. If we move on down the slide, you’ll see our adjusted operating expenses at $549.8 million, increased by $9.8 million or 1.8% relative to the first quarter. Foreign exchange increased adjusted operating expenses by $4.3 million during the quarter. The adjusted employee compensation line item came in at $360.6 million, that’s a decrease of $0.6 million or 0.2%. This is driven by a decline in seasonal payroll taxes. That always happens first quarter to second quarter. But it was offset by an increase in variable and other compensation costs, a full quarter of higher base salaries effective March 1 and an increase in deferred compensation expenses for the awards that were granted in the first quarter. The foreign exchange impact for our adjusted employee compensation came in at $2.5 million. Looking forward, again, to the guidance, we’re assuming AUM and foreign exchange flat to current levels. We’d expect compensation to increase ratably to about $370 million by Q4. This increase in forecasted compensation costs includes the – several factors, including: The impact of the Source acquisition in the third quarter; investments that we’re making behind some of our key strategic initiatives, including building out our institutional business, solutions, ETFs and Jemstep as well as resources that we are adding to meet the growth in regulatory and compliance requirements on a global basis. Our adjusted marketing expenses in Q2 increased by $4.7 million or 18.8% to $29.7 million. That reflects an increase in advertising and client events. Foreign exchange increased our adjusted marketing expense by $0.3 million. Marketing costs should stay roughly flat to current levels until Q4, at which point in time this could grow to somewhere around $36 million to $38 million, consistent with the historic seasonality that we’ve seen in the past. The adjusted property, office and technology expenses were $88.7 million in the quarter. That’s an increase of $3.1 million or 3.6% over the first quarter, due to higher outsourced administration and software costs. Foreign exchange increased our adjusted property, office and tech expenses by $0.7 million. For the remainder of 2017, we see property, office and technology costs coming in between $92 million to $94 million a quarter. This is due to the impact of large technology-related projects that have and are coming into service as well as the outsourced administration expenses driven by the activity within our European cross-border business which should move the activity. Next, we go to adjusted general and administrative expenses at $70.8 million. That increased $2.6 million or 3.8% quarter-over-quarter. The G&A increase was largely driven by professional services costs associated with the regulatory changes and compliance that we’re seeing on a global basis. Foreign exchange increased our adjusted G&A expenses by $0.8 million. We would expect G&A as a line item to remain at similar levels as in the second quarter or slightly elevated levels for the remainder of 2017, somewhere between $70 million and $73 million per quarter. So finishing on the topic of expenses, I’d like to emphasize that I do believe the organic and inorganic investments that we are making will serve as key business differentiators for Invesco, and therefore, are critical for our long-term success in what we see as a rapidly changing competitive environment. With that said, we will continue to be highly focused on cost optimization efforts in order to remain as efficient as possible and to help fund these investments. So finally, moving down the page, you’ll see our adjusted nonoperating income decrease $10 million compared to the first quarter. This decrease was primarily due to the gain realized on our pound sterling-U.S. dollar hedges in the first quarter. And moving to taxes, the firm’s effective tax rate on a pretax adjusted net income basis was 26.7%, which brings us to our EPS at $0.64 and adjusted operating margin, 39.3%. So with that, I’m going to turn it back over to Marty.

Thanks, Loren. I do want to do two quick updates before we turn it over to Q&A. One on Jemstep and the second on our EMEA business. And many of you probably saw the news that the Advisor Group, which is a network of independent advisory firms announced a new platform for its 5,000 advisers they support. The comprehensive digital onboarding advice and data aggregation program for their financial advisers was launched in alliance with Jemstep, which is our adviser-focused digital solution business. We view – we view this as a further sign that Jemstep/Invesco combination offering digital advice platform as tremendous value-added technology in our sector and it is resonating in the marketplace. The platform extends to both advisers and their end clients to strengthen their relationship and will be used to support advisory and brokerage business models, which as far as we can tell, is unique in the marketplace. And as noted on previous calls, it’s early days, but we do see Jemstep as having meaningful potential in the market for us. With regard to EMEA, we saw the fourth consecutive quarter of positive long-term net inflows in the region, which totaled nearly $3 billion in the second quarter, despite a large one-off sovereign wealth fund redemption. Quarterly gross flows for the region of $14.3 billion were the highest since the first quarter of 2015. Long-term flows into the cross-border retail totaled $4.1 billion for the quarter, and our Global Targeted Return fund remains in high demand, with inflows of $2 billion during the quarter. We did not purchase any stock during the quarter, instead reserving a portion of our available cash for the planned acquisition of Source, the leading specialist provider of ETFs based in Europe. We are making very good progress on the regulatory approvals and remain on track to close the transaction at the end of the third quarter. Net inflows into Source have been strong year-to-date. We remain focused on planning the combination of our two firms, building on Invesco’s significant expertise and track record of bringing companies together for the benefit of clients, employees and shareholders. We really are excited about this opportunity and we do think the combination of our ETF with Source, in Europe, will really be a meaningful addition to the company. So with that, I will stop, and Loren and I will answer any questions anybody has.

[Operator Instructions] And our first question is coming from Ken Worthington of JPMorgan. Your line is open.

Hi, good morning. First, I wanted to dig more into the institutional sales. So can you give us a little more flavor about the slowdown in Asia, and how the Asian-specific pipeline is looking and maybe where the conversions in Asia have fallen off? And then, why aren’t you seeing the weakness in Asia being offset by conversions of the strong pipeline elsewhere? Then lastly, can you give us maybe an outlook for the second half of the year on the institutional side? Any conviction in moving back to positive sales there?

Yes, Ken, let me hit a couple of those and Loren can chime in. So just literally with regard to the won but not funded pipeline, that continues to remain strong and it is just a fundamental fact, we’re not making the decision of when the organizations are going to finish their processes to fund. So we see it simply as a timing topic, nothing to do with a falloff in success of the business. Where it has gotten softer after a very, very strong 18 months is really in Japan, where it has been just – that big change in some of those big plans. We were a significant beneficiary of it, and literally was funding almost every single month. So at some point, that – it stops. So it’s flattening off more than anything else. So those would be the two comments I would make. Anything you’d add?

I mean, I do think we’re still pretty optimistic about the overall story on the institutional side, for sure. The fee rate on flows are at a much higher level, continues to be sort of record highs on the aggregate basis points. And then, that weakness, as you suggest, is being offset in other locations. Europe is quite strong. So again, we – I think it’s more just an aberration around just a confluence of things that happened in second quarter as opposed to a real inflection point indicating that something’s at a whole new level of decline. So the thing that I would say is we have pretty good line of sight on the won but not funded, and that’s what I’m referring to right now. When redemptions happen, which they can, that’s harder for us to predict. And so we did get caught offsided by one large sovereign wealth outflow in the quarter, which was pretty sizable, $1.2 billion. And those are hard for us to really see. We don’t expect those to recur, but again, we don’t know.

Great. And then just on PowerShares, it looks like PowerShares is looking to launch some market cap weighted ETFs. Somewhat of a departure from the smart beta focus. Can you talk about what PowerShares is doing here and if there’s any tie back here to Jemstep?

Yes, good question, Ken. So it is two things, it’s not just Jemstep, but also solutions. And really, as we build the models, in line with what clients are trying to accomplish, they do use cap-weighted indexes in there. So it’s not as a single solution but as a part of a total portfolio. And we’re very capable of managing cap-weighted indexes, so it’s for solutions and frankly, also into Jemstep, where a number of models have been built to give various choice to the different participants. So those are the two focuses there.

Great. Thank you very much.

Thank you. And the next question comes from the line of Patrick Davitt of Autonomous. Your line is open.

Thank a lot. First question is just around the broader European kind of regulatory environment, particularly as so much of your growth is coming from that region. Do you have any change in position or more specificity on the impact of MiFID II on your business and/or profitability? And then, more recently, any kind of initial reaction to the FCA review and your positioning for their major proposals?

Yes, let’s – with MiFID coming on, like everybody, it’s been – an awful lot of work, heads down. We really see no different – we do not have a different point of view today than we have over the last number of quarters. It is more work, it’s not going to dramatically change our business. I would say, this and also in combination with the FCA work, it ultimately does favor larger firms that are capable of working through these topics and frankly, can afford the additional costs to meet the regulations. Back to the FCA, it did make a number of recommendations. Some of the principal regulations we’re already in line with. So one of them was to have a single fee. We did that a couple of years ago. So we’re beyond that, and I think some of the areas that they’re focused on, greater transparency and the like, some of the early suggestions, again, we are supportive of those types of things. We, like others in the industry, will be commenting during this period and try to help give greater guidance, but again, it is something that we feel very well-positioned. They were also focused in particular on really, what they would sort of call closet indexers. Needless to say, that’s not even close to a topic for us, and the investment performance of our teams over a very, very long period of time is just really outstanding. So again, it’s a burden for the overall industry, but again, with the idea of making it a better industry, which is we are very supportive of. But again, we think we’ll be fine once we get through this.

And Pat, just to remind you, I mean, we did come out, I think it was last quarter, in terms of our position with respect to the use of commissions on research, and so we said that we were going to continue to focus on, within the – of our ability within MiFID II, to use CSAs to fund RPAs, which would mean that there’s not a substantial impact on cost for us, as long as competitively that’s still, and from a regulatory perspective, that still makes sense. The other thing is, just in terms of positioning, and we have a substantial number of people on the ground, have for a long time, in Continental Europe. So the idea of what would ultimately happen, in terms of having risk and foreign oversight of capabilities in terms of this passporting topic and so forth, is another thing that I’d say we feel probably better position than most others in the region. So overall, I’m not saying there’s no cost there. There’s probably some cost, but I don’t think it’s going to be a substantial material cost at this point in time.

That’s very helpful.

Thank you. And the next question comes from the line of Michael Carrier of Bank of America Merrill Lynch. Your line is open.

Maybe just one on the expense outlook and then just thinking about kind of the incremental margin in this environment. I just wanted to get a sense, it seems like some of these investments you guys are picking up or ramping up, like how much flexibility do you have there? Are you doing more, because the market environment, you guys have been a little bit more constructive? I just wanted to get your sense on how you’re thinking about the margin in this operating environment?

Let me make a comment, and Loren can, too. So as we said, there’s no question that the industry is going through quite a bit of a change. And clients are demanding different things from organizations. So simply having a range of capabilities perform well is not going to get you over the goal line, regardless of retail and institutional. And you absolutely have to have the ability to meet client outcomes with things like solutions. This movement into Jemstep to support our financial advisers, we think, is very, very important. Things like thought leadership, they are not optional value-added capabilities. And so we think it’s really important that we continue to responsively invest against those, which we are doing. We think it’s just making the firm much more competitive and better-placed for the longer-term. And yes, it does make it easier to make the investments in a strong market. We’re trying to get them done as quickly as we can, but again, with very much a responsible lens on being financially sound during the process.

Yes, really not going to add much more to what you said, Marty, other than, I think, quantifying. In terms of incremental margin, I mean, I think we’re probably at a level that’s more in the 40% to 50% range incremental margin, as opposed to sort of the 50% to 65% right now, just because of our imperatives to make sure that we build out the capabilities that are going to be critical to our success and trying to do that now, but responsibly in the sense that we’re continuing to find opportunities to save and to fund those. So you’re going to see operating leverage, you’re going to see margin expansion as we grow. All those things should absolutely continue to be in place, but maybe not quite at the level of lower investment type of positioning.

And I just might come back and add. Ken was asking some questions a few minutes ago. So we look at things like the institutional pipeline over quarter-to-quarter. That’s not the way we look at it. From our perspective, we look out 1, 2, 3 years, and we look at it as a very, very important part of our future success. And as I said, I feel very good about the leadership in place. I feel very good about the responses we’re starting to get from clients as we are dealing with them in a more robust way. And again, it is not a – the assets just don’t go straight up. They are choppier, just by the nature of the long-term, our fee process, et cetera, et cetera. So again, that would be another area where we just think it’s really important that we do a good job.

Okay, all that makes sense. Just on capital, so post the Source deal, just wanted to get a sense, anything changing on how you guys are thinking about you know, kind of buyback activity, just given that we’ve been in this lull between the deal?

So I think it is our capital policy and approach remains in place. Obviously, we smartly, I think, are pausing on the buyback just so we can fund this acquisition. The opportunity set for things in this industry around consolidation is at a high level, too. So I’ll just generally say that we’re seeing probably more inorganic opportunities than we have in the past. Certainly, that doesn’t mean we’re going to do something else other than Source. But I think our general position is one of this is a unique and extraordinary time, and so we may continue to be thinking about the balance of cash to return, versus opportunities in the market that might not show themselves again, so. And again, it’s a little bit hard to say exactly, but we are generally, I’d say, back in our normal return mode post-Source.

Okay. Thanks a lot.

Thank you. And the next question comes from the line of Dan Fannon of Jefferies. Your line is open.

Thanks. I guess, just another question on expenses. You have this business optimization plan that’s also in place, where I think you in the press release, highlight sort of more run rate savings going into 2018 now. I guess, if we think about the guidance you’ve given for the remainder of this year, how much of this is reflective of some of the new – the incremental spend of compliance and growth, but then you obviously have Source and you’re offsetting this with some of these business optimizations. So I guess, is there a way to kind of bucket some of these in terms of categories of the incremental spend?

Well, I tell you, I mean, into the second half, certainly a substantial part of the expense pickup is just related to Source. Again, you probably have a reasonable sense of kind of the revenues and expenses for that business based on what you know about that business, so you can kind of do the math and see where that’s breaking out. The optimization impact is going to be most felt in 2018, because we have some very large-scale projects that are not going to get completed until 2018. And it’s only until that happens will we see sort of the remainder of the – to the full 50 run rate show up. So I’d say, through the second half of this year, there’s definitely some offset of the investments through optimization efforts, but not incrementally a lot. So I don’t know if that fully answers your question, but I’d say at least half of the expense pickup is due to Source and the other half is just due to the investments that we’ve been making, generally.

Got it, that’s helpful. And then, Marty, I think in the press release and in your comments, you mentioned stable value as being kind of a source of redemptions. Can you talk about that and why that wouldn’t be, or are you anticipating that to continue to be a headwind, given some of the client reallocation in that bucket?

I don’t. Look, I think it’s just the normal course of people doing their allocations with their 401k plans and here we are, 2017 and what has been more or less an extended bull market and people seem to be in some of these plans, moving out of stable value into some higher risk/return products. Whether that’s the right timing or not, I’m not sure, but that’s not my decision. I think what I would point to probably is the – and this is no new news to anybody following the company, but the headwinds of the UIT business, I mean, that continues to be one that is not immaterial when you look at the relative flows quarter-to-quarter. And again, we’re just going to have to see where that goes as things settle out with the – as the platforms rebalance what they want to do in light of the DOL fiduciary rule. So I would point to that as the more topical area than stable value. Stable value, I think, will continue to be solid.

Got it. Thank you.

Thank you. And the next question comes from the line of Bill Katz with Citigroup. Your line is open.

Thanks for taking the question. Just a technical question before I get to the meat of the question. Did you mention that the marketing spend would be in that $38 million range in Q3 or it sort of tip-toes there by the end of the year?

Marketing’s going to be roughly flat to what it was in the second quarter, and it’s really just in Q4 where it goes to that higher level.

Got you. So the other question was, just sort of staying on the expense theme, what’s the life of the incremental spend here? So I appreciate you’re taking the incremental margin down pretty substantially, and I guess half of that is from Source, but is there a more structural change in the business model here, maybe for you and maybe the industry at large? Because it seems you already have some in terms of the investment spend. So when you get on the other side of this hump of spending, are you back into that north of 50% incremental margin or are you just now at a structurally less incrementally profitable point?

I think this is not a structural topic. I think it’s more building around what we see as absolutely key points of differentiation in growth that we want to be ahead of as opposed to sort of running behind competitors and the industry trends. So I think we’re doing a lot and we’re really, I think, getting through the bulk of what we need to get through. It will probably persist into 2018, I’d say, for us to get to sort of an equilibrium point, but I don’t think it’s a structural ongoing theme in terms of incremental margins for us.

Yes, I agree with that fully, Loren’s comments. And again, I’d just come back to we all thought it’s been a competitive business, over our careers here, but I will tell you, I mean, this is a very different time. And if you are not investing for the future, in a very rapid way, you’re going backwards. And so again, we are – we think we’re being very responsible. We are seeing the results in very different areas and I think if you look at what we’ve done over the years, we have a track record of the investments paying off in a pretty material way and that’s what we think we’re doing right now. Are they all going to be perfect? No, they’re not. But we feel quite confident the vast majority of them will be very important to the firm.

Okay, and then also looking at some of the flow matrix, sort of focusing in on U.S. equity. You look at some of the slide decks and performance trends, they continue to be somewhat checkered. How are you thinking about that business in light of just the ongoing commoditization risk to passive. Is this an area that – is this an area you could accelerate on the investment spending side to potentially enhance returns? Is it just a timing or cycle issue, just sort of work through some weaker performance? Just trying to get a sense of what would alleviate that pressure point.

Yes, look, I feel really good about our investment teams. And yes, has there been a headwind in U.S. equities in particular? Yes. Do I think – I personally think it’s an incredible mistake to be putting your 100% of your U.S. equity exposure into cap-weighted indexes. There’s going to be some very disappointed people that have done that. And if you look at the U.S. value capability in particular, relatively underperforming, they are doing exactly what they should be doing, being 100% committed to their investment process, they will do very well. And when we saw the spike at the end of last year, after – if you want to call it after the election, through the end of the year, it picked up 1,000 basis points against cap-weighted indexes. So again, it’s very easy to say it’s different this time, and I just – we’re supporters of passive and factor and active in a – very clearly, but I think it’s a mistake to give up on active at this part of the cycle.

Got you. Okay, thank you very much.

Thank you. And the next question comes from the line of Alex Blostein of Goldman Sachs. Your line open.

So just staying with the expenses and the margin dynamic. Just one point of clarification. Do you guys expect to be at the 50% to 60% incremental margin in 2018? Or the investment spend that you are seeing in the back half of the year is likely to continue beyond that point?

Yes, I think the 50% to 60% is probably post-2018, based on what I just mentioned in terms of the higher level of investment and we’re probably setting expectations, realistically, that would be in the more 40% to 50% for this year, next year. So that is kind of where we are right now. We haven’t, obviously, fully completed our plan around what we’re doing in 2018, and a lot obviously will depend on where the markets go and where the mix of products go. We’re definitely, I’d say, it’s a good thing that’s very helpful for us is the fee dynamic is working in our favor, with the strength that we’re seeing in the cross-border business, and as Marty said, it just continues through July, very strong flows, that is very helpful. And the fact that the pound is now at 1.31 and strengthening, also is going to be extremely helpful for our yield. So that could actually help our net – my incremental margin discussion. But assuming flat markets and flat FX is what I’m referring to.

Right. Okay. And I guess, bigger picture question, so you guys – I totally understand why you’re spending where you’re spending and the segment changes in the space, but at the same time, the – a good chunk of the equity business in the U.S. is underperforming on a 5-year basis. I mean, U.S. core business is struggling. So I guess, why not pull back and create a little more of a cost reduction on that part of the business to fund some of the initiatives that you’ve highlighted?

Yes, I think that could be just about the biggest mistake somebody could make, as far as I’m concerned right now. They are high-quality teams, they are very, very good at what they do. And investors, our clients are going to do very fine with them through the market cycle, and that’s how I feel.

Fair enough. And I guess, just the last one, on Source. I don’t recall if you guys gave us the amount of cost synergies that you anticipate to have from that business once that closes. Just kind of perhaps how long it will take to get that out of the run rate?

Yes, we have not provided a lot of transparency into the synergies topic. Again, in terms of the materiality, it’s all going to be within our guidance that we’ll obviously provide for 2018 and beyond. And certainly, some of it is already baked into the estimates that we provided you. It’s mostly a growth topic for us, as we said in the past. There’s definitely some overlaps that will allow for some cost take-out, but the real benefit for this platform is us growing through flows, and as Marty mentioned, it is flowing beautifully, right, very nicely. And so we think we can actually significantly improve flows out of that business. We are looking at a lot of new product launches, so really, the – it’s going to be more of investing behind the business than taking cost out. So that’s why we really have been focused on it.

Great. Thank guys.

Thank you. And the next question comes from the line of Brian Bedell of Deutsche Bank. Your line is open.

Thanks for taking my question. Maybe just an update – some updated thoughts on DOL fiduciary rule timing, maybe both in how you think distribution partners are currently positioned and will react on the active mutual fund side, including financial adviser views. And your view of, to what extent do you think that clean shares will become much more dominant in the marketplace? And maybe just long-term views on whether the BIC gets restructured for January 1, 2018?

Let’s see. So maybe let me try to put it in context of the big picture and I – and again, we’ve said this before and other have. It’s just very, very clear that the fund – the distributors are moving to a financial advisory model across the board and that was a direction of travel anyways. I think the DOL fiduciary rule really just sped that up. So I think everybody sees that clearly. The – I think with regard to the BIC, I think there’s anticipation that it will be modified quite materially to ensure that financial advisers and investors have choice, because it really does get in the way of investors having choice, which means it gets in the way of people building robust, meaningful portfolios with a combination of active, factor-based portfolios. So I think that is important. I think I would put it in the category of people are hopeful that it’s going to happen and it really needs to happen before we move into the next year. So I think the best top of mind on everybody’s to-do list is we continue to try to support that change.

And any commentary on clean shares and or T shares, I guess?

Yes, it feels like clean shares, over time, make an awful lot of sense. I think it’s going to follow the transition to the advisory model where I think that would be a really good thing, because right now, mutual funds are disadvantaged from the standpoint that they are really a paying agent, so it makes the expense ratio really inflated when you look at it vis-a-vis something like an ETF, because you are literally paying for service and distribution costs in that model. In the advisory model, the overall fee is what is paying for the financial advice and the mutual fund within it would have the clean share lower expense ratio, and frankly, would be on a more level playing field with things like ETFs. And again, vehicles are not ways to meet investment objectives, but they are – they have different attributes which are helpful to different situations. So that’s probably where it’s going to end up, but it’s probably going to take a couple of years to get there, I would guess.

Okay, that’s great color. And then, just maybe your updated views on large-scale M&A. First of all, it was interesting, I think, Loren, what you talked about, potential opportunities or the market getting to a point where there, looks like there might be more opportunities for you guys to acquire things. And maybe just some commentary about what you may need to fill out an already, pretty diversified product set. And then, broader picture for Marty. You commented on this before in the past, so just maybe your updated views on large-scale consolidation in the active – or in the asset management industry. Given active performance actually has improved this year so far, but keeping in mind like what you said in terms of investing for the future, if you’re not doing that, you’re falling behind. So do you see that, I guess, environment for large-scale consolidation even more appealing now, than say, 6 months ago?

Yes. Let’s see. I still believe the likelihood of more combinations and meaningful combinations is more likely now than probably any time in my career for all the dynamics that we all know that we’ve been talking about. It continues to be difficult to do successfully. And – but I would say, firms that combine when they both are strong, much better likelihood of outcome. I think it’s those firms that are two struggling firms and you put them together, that I think is a very difficult situation, quite frankly. So the good performance might actually enhance some of these combinations or the likelihood of them. But again, I think it’s really the firms that are U.S. retail-focused firms that are midsize are probably the most challenged, and with all the dynamics that we’ve been talking about. So yes, we’ll just have to see what happens and it’s hard to predict and it always takes longer than anybody would imagine. But Loren, would you add something?

Yes, and the only I would just say is when I was talking about – I wasn’t necessarily referring to large-scale opportunities, because I think we’ve talked about those are hard to do, there’s a lot of risk, there’s a lot of complication. So I think the types of things that are most attractive to us would be things like Source, that are smaller, that we could plug in, gives us a platform or capability that we didn’t have before and that we can grow quickly. So that’s really, I think, in terms of what we would be thinking about more, than large-scale.

Okay, its great color. Thank you.

Thank you. And now we have Chris Shutler of William Blair. Your line is open.

Given that expenses are a popular topic today, maybe just summarize the major incremental investments that you’re making. I think you mentioned institutional solutions, Jemstep, there may have been others I missed. Can you just walk through those one by one and give us a few more details on each of them?

Yes. So I mean, and Marty, you can pick up on the theme, building our institutional business is something that we’ve been talking about in the past. You know, I think we have been more retail-focused as a firm and for us, in terms of getting to being seen as a premier institutional player, requires a lot of dedicated support and infrastructure, risk and analytics and reporting and a variety of infrastructure that we just didn’t have in the past. That really, [indiscernible] manager, there’s a whole infrastructure around building that out. Thought leadership is another kind of element. So that’s – handful of the people, but very capable and good people, that help drive that cost. Solutions is another area that we talked about and that is, again, a very – an area we’ve been in, but really haven’t built a lot of strong capabilities around, particularly around the technology, and as I mentioned, the analytics for us to be able to sort of go off and really, almost like in a lab, figure out how to solve our clients’ problems through a variety of folks that are a lot smarter than me, PhDs and others, that are thinking about those issues. So that’s really that group and that appeals to both the institutional side, but also the retail side. And then they are very helpful, in terms of thinking about Jemstep as well, in terms of providing models and solutions to the retail clients. ETFs was the other area that you – we mentioned, and that’s more inorganic, and obviously Source, for us, but certainly, the ability to take some of those capabilities and port them over to the U.S. and think about the digital platform and being the best-in-class provider of smart beta and differentiated ETFS is still kind of what we’re trying to do and being – not be a distant fourth but be a strong fourth, at least a bit in that space. And Jemstep, they’re really savvy in digital advice, which I think is going to continue to be a major opportunity and certainly, firms that have it are going to being differentiated from those who don’t. So we need to have a state-of-the-art capability and it’s one that requires a whole different set of skill sets, and so that’s kind of the other big bucket. And the other one I mentioned, which you know, is the regulatory and compliance, which is just never-ending.

Yes, I’ll just add a little color, just on the solutions piece. Again, I think it’s a common word and I think it’s misunderstood. I think people tend to think of it as dealing with large institutions. I mean, we look at it at 3 levels, as Loren was saying. So it literally is at the large institutional level, that’s a fact. What has been surprising, the opportunity of solutions at the retail level, because as all the channels are moving, the financial advisers are moving too to be much more solutions-oriented or outcome-oriented with their clients. And our ability to build portfolios for them, whether they be in models or literally help them with their books through our range of passive, factor, active capabilities is really, really important. And so – and the third leg is Jemstep, right? And really, building these models for Jemstep is really quite important. And let me go back to, I just mentioned one group. So the adviser group of 5,000 advisers, so it’s more likely than not, and I’d say very likely by next year. So those are 5,000 advisers we’ve never worked with before. It’s very easy that we can be working with 20,000, 25,000 advisers next year that we’ve never worked with before, because of things like Jemstep. So the combination of these things that we’re doing is broadening our distribution channels, serving our clients in a very different way, which really creates the robustness of what the future could look like for the organization.

Okay, and just one other one on the fixed income area. Looks like flows there in active fixed income been okay over the last few quarters, but I guess I’m wondering why they haven’t been better, just given the really – the terrific performance you have in that area. Is it investors adjusting durations in their portfolios or is there some other factor going on?

That’s all, I mean, really, the biggest detractor from that category has been stable value. So that was substantial outflows this quarter. So it’s a very low fee, 10 basis points kind of -ish. So again, when I think about the flows in versus out, our net revenue yield is, by far and away, moving up in that category. So I wouldn’t take too much out of that stable value outflow.

Okay, it make sense. Thank you.

Thank you. And the next question comes from the line of Chris Harris of Wells Fargo. Your line is open.

Another one on the investments you’re making. In a perfect world, how quickly do you guys think some of these investments are really going to start pay off and potentially start showing up in flows? Is it a short lead time do you think? Or is it sort of a multiyear effort that’s going on?

I’ll try to hit some of them. Institutionally, you’re already seeing it. Solutions, it’s happening. Is it at the level that we think it’s going to be? No. It’s early on. But you’re literally getting payback. Jemstep tends to be the longer-dated one because, again, you’re actually doing an installation of an application, which I think we’ve all lived those experiences. It just takes time. And so that would probably be the timing, and I say you’ll start to see, in each of those 3 different levels, flows will continue to pick up in the quarters ahead and next...

ETFs will be almost immediate, right, because we have Source coming online.

Yes.

Okay, great. And then a follow-up on the fee rate. Loren, I thought I heard you say the second half sort of flat with Q2. Is that correct?

Yes. Really, a result of these two dynamics. One, we’re seeing the fee rate improve due to the mix and foreign exchange, so that’s like a 0.5 basis point upward tick, which has been getting flattened out, just purely from the consolidation of the $25 billion, at 16 to 17 basis points of Jemstep – I’m sorry, of Source.

Yes, okay. I mean, it would seem to us that Source would have overwhelmed the other positive, but I guess, apparently not. I guess, the fee rates sound like there’s an incremental positive going on into Q3 that offsets the Source, I guess, is what the message is, is that right?

That’s correct.

Okay, great. Thank you.

Thank you. And the next question comes from the line of Brennan Hawken of UBS. Your line is open.

Hi, thanks for taking the question. Just a couple of quick follow-ups. First, on clean shares and the outlook for this becoming a solution in the – particularly in the adviser broker solo channel. Who do you think or how do you think the sub-TA piece would be funded? And how have negotiations with your distribution partners gone on that point? Is that something that you think might have to be funded by the P&L of the sponsoring asset manager? Or would it be something that the distribution partners are going to be okay with losing that revenue source?

It’s a good question. I’d say you’re ahead of really all the conversations and there’s not a direct – it’s not clear where everything is going to settle out. And I think much of it depends on where the DOL settles out. So again, I would just be totally speculating on what the structures might look like at the end. So wish I could be more helpful, I just can’t right now.

Okay, that’s fair, that’s fair. And then, can you give us – I know that you guys have said that you expect pretty much everybody signed up for RPAs and it sounds like you’re continuing to reiterate that point. So I’m guessing that early-stage negotiations with clients are supportive of that. Is that true? Are there any early reads you can give us, particularly on the institutional side, in how that’s going and what your expectations are for any application of some of these practices globally for Invesco?

So based on what we understand in Europe, which is where this conversation has been most focused and relevant, client reaction has been pretty much absolutely accepting of that perspective. We’re not alone in terms of the global – a lot of the global managers have come out with a very similar statement. So it’s actually been pretty much accepted. Ultimately, I think, when – the real trick will be in terms of the actual disclosures. And when it will ultimately get implemented, we’ll have to see how all that goes. But certainly, in terms of the position, it’s been accepted without much of a, any pushback. In terms of the global side, I don’t know, Marty, if you think that we’re thinking about doing that globally? I don’t think at this point we’re in a position to say what we’re doing in the U.S. different than normal.

Yes, no, we’re continuing down the path that we’ve been on.

Okay. Thanks for the color.

Thank you. And the next question comes from the line of Mike Cyprys of Morgan Stanley. Your line is open.

Hi, good morning, thanks for taking the question. Just coming back to the investment spend. You spoke about a lot of the challenges that the industry faces and the need to invest. So I guess, why not invest more than the amounts that you guided to? What was the thought process behind that? And what gives you confidence that you’re investing enough to be successful and drive future growth?

Yes, look, that’s the right question, we ask it all the time. And again, we think we’re on the right topics. We think we’re making progress on the right topics. And the fundamental base is just that. Are you investing enough and what we really constantly are doing is ensuring that we try to free up, reallocate dollars to the things that are making a difference. Loren has spoken in particular about the various areas that we try to create room for investments, and that is our process. Can’t answer it specifically, because it’s what we do each and every day. But we are thinking the way that you’re thinking.

Okay, and if you were to expand the investments and the pace, what other areas could make sense? And then just on the regulatory compliance spend versus the others, how should we think about the split in terms of how much of the spend is going for regulatory compliance versus growing the business?

Yes, the majority of it these days is going for growing the business, which – and I think we’re on the right topics. I don’t think we’re missing. We are investing on the things that we think are going to make a difference. The regulatory spend is no different than any other of our competitors. It just seems to be constantly an area where you have to invest in, and not just regulatory, but I would put cybersecurity in that category, too. I mean, there are areas that we just, 5, 6, 7 years ago, it was just not an area we had to invest at this magnitude.

I guess, what’s changed on the regulatory side over the past 12 months? Because certainly, this has been a theme that you and others have been speaking about for some time in terms of driving spend. What sort of changed in terms of what you know differently today versus 12 months ago versus two years ago?

Well, part of it is, as the regulations come out, they’re proposals, and you work through the process of having them put in place and then implementing them. So you’re actually – you’re now in the implementation stage of a number of these regulations in different parts of the world, and that’s really why you’ve seen the costs start to hit more recently, the last 12, 18 months, more in particular. And I’d say the same thing. I just look at where we’re spending money, on cybersecurity and security, generally, over the last couple of years in particular, it’s just ticked up to a degree that, yes, we were spending before, but it’s just at a different magnitude that you have to spend to stay ahead of the issues. You don’t want to read about yourself in the paper, right?

Penalties, like I mean, that privacy rule, where, if you get it wrong, it’s 2% of total revenues could be your fine, right. Pretty substantial element. So I think it is the regulatory – the number of regulatory changes plus, I think, the amount of resources that regulators are putting behind the asset management business now relative to two years ago has also increased, and so the level of being absolutely on top of it is – the bar has risen across the globe in terms of what is required.

Great. Thanks so much.

Thank you. And the next question comes from the line of Kenneth Lee of RBC Capital Markets. Your line open.

Thanks for taking my question. I just had a question on the Source acquisition. My understanding is that ETFs right now don’t have the same level of penetration in Europe as they do in the U.S. due to market structure. Just what sort of milestones do you see ahead before you see, like a meaningful increase in penetration in ETFs within Europe?

You’re right. The penetration is not there in Europe. Our anticipation is that it will continue to see greater penetration in the years ahead. If you look at the history of the growth in the United States, and you look at the path where Europe is on now, it’s some years later, but it seems to be following the path, with greater adoption. There was also an important evolution with the ETFs, too, where they were derivatives-based, and now there’s more physical ETFs, too. And so you’re broadening the potential users of derivatives in Europe, so we’re anticipating that’s going to continue to be a growing marketplace for ETFs and the penetration to – of ETFs to increase.

Yes, and probably even with some of the rules around MiFID II and the transparency on fees, and whereas there maybe not has been as much, and certainly, the idea of no inducements provided for manufacturers, distributors and how that gets implemented, feels sort of like RDR part two...

Yes.

In Europe in some ways, and we know that that’s focused on just pure management fees. It will probably drive more adoption of lower-fee products, still within the hands of European retail clients as opposed to institutional clients who are using ETFs predominantly.

Great. That’s all I have. Thank you very much.

Thank you. And now we have Robert Lee of KBW. Your line is open.

Thank you, thanks for taking my question. I have – maybe just want to go back to, Loren, your MiFID comments, because I may have missed some of it. I guess, two parts, and number one, is it still your expectation, I know it’s still somewhat in flux, that you won’t have to fund, outside of spending on systems and stuff, you won’t have to fund it off your P&L at this point? Or how do you kind of think of that as a go-forward risk?

When you talk about outside systems, are you talking about...?

Well, reporting systems. I mean, I know you’re spending money on the compliance side of MiFID, right, but I meant more just in terms of the commission side of it.

Well, the commission side, again, that’s the part that we’re saying would probably stay in terms of being paid through these RPA accounts funds and clients paid for, and transparency for research. So that’s the current approach. So that would be largely sort of a continuation of existing P&L and practices other than sort of having those structures in place. So there would be no significant P&L impact to Invesco.

Okay, great. Just wanted to clarify that’s your current thought. And I guess, if I look at flows, I mean, maybe thinking of them in a different way. You’ve kind of, I think, talked to this, but if we look at the modest outflow this quarter in aggregate, what’s the – how should we be thinking about that, really, from kind of a net revenue contribution perspective? So I mean, stable value, as you pointed out, is low fee. You’ve maybe had some other things. So how should we be thinking of your expectation for the net revenue contribution of the quarter and also go-forward?

Yes, positive. So the net revenue, the flow mix dynamic, given the headline was kind of not great in terms of the net flow number, I was actually really pleased. If you peel that back and you understand what’s flowing in terms of the strong flows coming into cross-border – into alternative opportunities which are certainly at a higher – being very active capabilities. So yes, when we were talking about sort of a 0.5 basis point pickup into next, the last half of the year, that’s all due to the positive trend around the flow dynamic that we’re seeing, even though it didn’t really show up in terms of the headline flow number. The big outflows, as I mentioned, stable value, which was single – 10 basis points, and we had the individual real estate passive outflow, which was a single point kind of – UITs as well, which is something that, I think we all understand that dynamic. It’s something that continues to be a bit of a detractor to the flow story, but not one that I think materially impacts our yield. So overall, I’d say that people should be looking beyond that headline number and focus on what’s going on, in Europe in particular, because that is going to have the biggest impact on our net revenue yield.

Okay. And then maybe one last question, just kind of maybe bigger picture. The one place in U.S. retail that seems to have some positive trend is clearly the SMA business, whether it’s model portfolios or whatnot. Can you maybe give us a sense of how you feel about your positioning in that business? Is that business a part of your retail business that you feel like you need to kind of make more investment in, that you have the right products in the right places? If you can maybe update us on that?

It is an evolving opportunity, there’s no question about it. We have the capability with mechanical SMA structures. We also have the ability through – to build the different models, and like everybody, it’s these models, I think, that are going to be taken up. In a number of the channels, there are opportunities right now without decisions being made, so we should do pretty well in that. But again, we’re not going to know until decisions are made in those areas. So again, it’s another area of growth as you look to the future. I think you’re right.

Great. Thanks for taking my questions.

Thank you. And we have no more questions in queue. I would now like to hand the call over back to our speakers.

Thank you very much, on behalf of Loren and myself, appreciate the engagement and the questions and we’ll be in touch.