Europe's asset management industry posted record operating profits but costs are also rising sharply and the industry may need to prepare itself for a downturn, warns consultant McKinsey. In its annual survey of the European asset management industry, McKinsey described 2006 as a year of "solid growth", with assets under management rising 12 per cent, although this was down on the 18 per cent recorded in 2005 and the 17 per cent witnessed in McKinsey's survey of the US industry. This asset growth helped push up aggregate operating profits by 20 per cent to €16 billion ($23 billion), finally overtaking the previous record of €15.4 billion set in 2000 – the height of the dotcom boom. But two-thirds of the gains came from market performance, rather than net inflows, and the fact that assets under management have risen from €6,700 billion to €10,000 billion since 2000 indicates how profit margins have been squeezed by a rising cost base. "This is an industry that, while it has recovered its absolute profitability and is still an attractive business to be in, has trended consistently down to lower levels of profitability per assets under management," said Andrew Doman, director in McKinsey's European Asset Management Practice. "We are concerned that the industry is not really thinking about its cost structure. It is structurally becoming less profitable from a shareholder point of view." Portfolio managers, in particular, are taking more of the returns. Expenditure on middle and back office operations and IT and support has not risen since 1999, when McKinsey conducted its first survey, as a proportion of assets under management. And while sales and marketing spend has increased slightly, from 3.5 to 4.4 basis points of AUM, the cost of portfolio managers has surged from 4.3 to 6.7 basis points, or from €2.5 billion to €6.4 billion. "Scarcity of alpha has led to portfolio managers being able to ask more or less what they want, leading to increasing capture of compensation by managers. We are worried about portfolio managers retaining more of the added value themselves," said Mr Doman. "We are seeing more and more companies moving towards a boutique or multi-boutique model, all of which casts light on the managers; they become the heroes. The star culture, which we had got away from since the 1990s, has come back strongly."