A “major shift” among asset managers could “dramatically reshape” the industry, says a report released today by McKinsey & Co.

According to “North American asset management in 2018: The New Great Game,” overall, 2017 was a great year for asset managers as global AUM grew to $88.5 trillion, a new all-time high, and industry profits increased by 20 percent.

During 2017, North American managers took in a record $683 billion in new net flows, according to McKinsey, and grew their own profits by 20 percent to $44.5 billion.

Global growth was particularly strong across three of four major regions in McKinsey’s analysis, North America, Europe and Emerging Asia. The fourth major region, Japan and Australia, experience $121 billion in net outflows during 2017.

However, most of the growth in asset manager profits in 2017 was attributable to market appreciation, according to McKinsey, and rising costs combined with fee compression and growing demand for low-fee products took a $5.7 billion bite out of North American asset managers’ profits. Most of the organic growth was concentrated among the largest firms in the industry,

Throughout 2017, investors fled active and high-fee investment products in favor of mostly passive and low-fee products. Three of the fastest growing asset classes for the year were passive equities, passive fixed income and passive multi-asset funds, while the biggest outflows were from active equities. In other words, investors and advisors are largely fleeing asset classes and products offering the highest revenue margin to managers in favor of the asset classes and products offering the lowest revenue margins.

Investors aren’t just moving toward passive, low-fee funds, but they’re also rejecting loaded vehicles for ETFs and no-load mutual funds. No-load funds experienced $922 billion in inflows in 2017, while loaded funds suffered $268 billion in outflows, resulting in $3.3 billion less in distribution fees that would have been paid out to advisors or other intermediaries.

McKinsey found that competitive dynamics are shifting among North American asset managers as trends like fee compression, regulation and demographic change force changes in the industry. This shift has successful asset managers shifting from organizing around elements like asset classes and “well-defined functions” to more horizontal integration and alignment with the client needs.

For example, the divergence in organic growth between large asset managers and small asset managers has increased to 21 percentage points in 2017, up six points from 2016. Large, $1 trillion-plus asset managers generated over 80 percent of all positive organic growth in the industry.

The North American retail channel accounted for $540 billion of inflows in 2018, 80 percent of the $683 billion total, with most of the remainder coming from the corporate sector, accounting for $111 billion of inflows.

Firms are trying to grow share using new products, technologies, business models, pricing strategies and via acquisitions.

Pricing is a clear example of where firms are trying to attract clients and access new markets. For example, Fidelity recently launched zero-expense ratio mutual funds, and Vanguard added more than 1,500 ETFs to its no-transaction-fee platform.

McKinsey refers to these growth-generating techniques as a “Great Game,” an allusion to the geopolitical competition between global great powers, regional powers and smaller states for influence in central Asia and the Middle East during the 19th century.

In such an environment, scale has become a more influential element in the selection of an asset manager, according to McKinsey, as “institutional clients are increasingly adhering to a credo of ‘fewer but more strategic relationships,’” while smaller firms are both reducing the number of relationships with asset managers and increasingly outsourcing investment management to an outsourced chief investment officer marketplace.

Thus, McKinsey believes that there will be increasing levels of consolidation among smaller asset managers who cannot keep up with the pace of change within the industry. There might still be room for smaller, innovative insurgent firms who operate within niches or can form alliances with larger firms.

To be successful, asset managers need “to clearly define their role in the ecosystem, to pick their spots (that is, where they compete) in a way that clearly aligns with their strengths, to build strategic alliances in areas where they choose not to compete, to back up their choices with deliberate resource allocation, and to create an operating model that delivers sustainable and scalable economics.”