Not many businesses deliver operating profit margins of more than 30 percent. But that’s exactly what the U.S. money management industry has been doing for the better part of 20 years.

In 2005 a good business got even better as cash streamed in, boosting fee income and driving revenue gains. Stock and bond markets were up — modestly in the U.S., vigorously overseas — giving a lift to asset values. Most significant, the average operating margin for publicly listed asset managers tracked by Merrill, Lynch & Co. sweetened by 150 basis points, to 36.5 percent, as of September 31, compared with a year earlier.

But in many ways the industry remains quite vulnerable. Fees are under pressure. Retail distribution is becoming ever more expensive. The main institutional clients, corporate pension funds, are either freezing their retirement plans, eliminating a source of asset growth, or demanding new products and services to better manage their liabilities. And considering recent market returns, a reprise of the bull market — which would solve all sorts of woes — seems an unlikely prospect.

“None of these things by themselves seem overly threatening, but in aggregate they are quite threatening to the status of the business right now,” says Kevin Quirk, managing director of Casey, Quirk & Associates, a research firm in Darien, Connecticut.

The likely result: increasing consolidation in what remains, despite years of mergers and acquisitions, a fragmented industry. Merrill estimates that there are more than 750 money managers in the U.S. alone. Two recent big deals — Legg Mason’s $3.7 billion purchase of the Citigroup asset management division last year and BlackRock’s acquisition of a controlling stake in Merrill Lynch Investment Managers in exchange for 49.8 percent of the new company that will be formed this year — could be just the first ripple in a coming wave of mergers and acquisitions.

“When a couple of very large financial institutions do it, others usually follow,” says Michael Rosen, a principal at Angeles Investment Advisors, a Santa Monica, California–based consulting firm. “We may well see more of the consolidation we saw in the mid-1990s.”

America’s biggest money managers, the II 300, reported having $26.6 trillion in their coffers at the end of 2005. That represents a 9.5 percent increase over year-end 2004 and a 43 percent gain over their recent low of $18.6 trillion, at the end of 2001. The entry hurdle was higher than ever, with the smallest firm on our list, Fortis Investments, reporting more than $5.2 billion in assets under management.

Barclays Global Investors holds first place for a second consecutive year, having grown assets under management to $1.5 trillion, an 11.1 percent gain over BGI’s total at year-end 2004. Net of market appreciation — the Standard & Poor’s 500 index rose 3.8 percent, and the Lehman U.S. aggregate bond index gained slightly more than 2.4 percent — BGI raked in $88 billion in new assets.

“Business was outstanding last year,” says Blake Grossman, global CEO of BGI in San Francisco. “Investment performance was generally very strong across our active, enhanced and index strategies, and the appetite from institutional investors for more risk-controlled, efficient portfolio solutions was stronger than ever.”

Second-place State Street Global Advisors saw assets under management grow 6.6 percent, to $1.4 trillion. Including assets passed to subadvisers, $36 billion of the firm’s gains came from net new inflows and $51 billion reflected market appreciation.

“Last year was phenomenal,” says Sean Flannery, North American chief investment officer for SSgA in Boston. “We had strong growth across the spectrum, particularly in our higher-risk active strategies.”

In the wake of its acquisition of Citigroup’s asset management business, Legg Mason ranks as the biggest dollar gainer in the II 300, having grown assets by 131.6 percent, to $858.3 billion, and catapulting through the ranks from No. 19 to fifth. More than $400 billion of Legg’s $487.7 billion in asset growth came from Citi, which ranked eighth a year ago. “The biggest growth area was probably fixed income,” says Raymond (Chip) Mason, CEO of Legg Mason in Baltimore. He’s referring to Western Asset Management Co., Legg Mason’s fixed-income subsidiary, which is known for core and core-plus products. (Since the Merrill-BlackRock deal was not announced until February 15, the two money managers are listed separately on the II 300.)

An earlier wave of industry consolidation struck in the mid-1990s, when financial services companies around the world paid top multiples for money managers, convinced that investment firms’ steady fee income — the annuity like revenue stream, in the jargon of the time — would help even out the ups and downs of trading and investment banking. And it did — until stock markets cracked in the spring of 2000.

Today’s consolidation has its roots in the 2003 mutual fund scandals, which made the industry more sensitive to potential conflicts of interest, as when a brokerage firm sells its own mutual funds alongside those of fund firms. There’s also a pervasive sense among bankers and insurers, as well as brokerages that the burden of running an asset management business — the demands on management time, energy and infrastructure — may outweigh the benefits of that steady and profitable revenue stream.

“People who have owned these companies often perceive those on the asset management side as very high maintenance,” says consultant Quirk. “Portfolio managers have to be coddled. As someone becomes more of a star, they become a more valuable asset, but then they can walk out the door and do something else.”

Among the Wall Street firms that own money managers, Lehman Brothers Holdings and Morgan Stanley are most often cited as potential sellers. Morgan Stanley CEO John Mack had discussed a possible deal to acquire BlackRock before the money manager made its own pact with Merrill. “When something like BlackRock comes along, we are going to take a serious look at it. Ultimately, we walked away from the deal because the price became so high it was dilutive to shareholders,” Mack said at a conference in New York on May 15. He insists that the firm is committed to the asset management business.

Goldman Sachs Group, whose Goldman Sachs Asset Management division ranks No. 14 on the II 300, with $496.1 billion under management, owns no retail brokerage. “We don’t have the inherent conflicts firms that are in the retail space have,” says Eric Schwartz, co-head of GSAM in New York.

Another force that could drive future deals: Many financial services companies may be looking to unlock the shareholder value in their money management operations. An asset manager typically sells at twice the multiple of an investment bank — roughly 22 times trailing earnings, versus 11 times recently. (Lehman had a price-earnings ratio of 9.8 in late June, Morgan Stanley 12.1.)

“The market does not look upon or give credit to many of those companies,” says Legg Mason’s Mason. “So it’s hard for them to have any value realization when it’s buried inside bank earnings.” In its deal with Citi, Legg Mason sold off its brokerage operation to focus exclusively on money management.

Of course, size is no substitute for common sense; deals should be struck on their merits. “Growth for growth’s sake is corrosive, whereas intelligent growth is additive,” says Angeles Investment Advisors’ Rosen. Consultants and industry executives expect to see more midsize managers be sold.

“Where it’s becoming challenging is for firms in the middle — with $50 billion to $60 billion in assets under management,” says Ronald O’Hanley, vice chairman of Pittsburgh-based Mellon Financial Corp., the total assets of which have grown 39 percent in five years. “They are large enough that they have to have significant absolute asset growth to get any kind of real percentage growth, and they can’t get it simply by doing what they did last year. That’s where you’ll see the consolidation.”

For both big and small firms, inflows held steady last year. More than $250 billion in net new assets flowed into long-term mutual funds and exchange-traded funds managed by the 517 money managers tracked by Boston-based consultant Financial Research Corp., 0.65 percent more than in 2004.

Investors of all sizes are looking to separate alpha — a manager’s ability to outperform the market — from beta, the return of the market. As they do, increased demand for cheap beta (index funds) on the one hand and for pricier alpha generators like hedge funds, venture capital and private equity on the other. Among the II 300, alternative assets grew by 17.9 percent, to $958.1 billion, last year. At the end of 2001, their alternative assets totaled just $344 billion.

“At one end of the spectrum, index managers are growing like a weed as investors look for cheap and cheerful ways to attract returns,” says Huw van Steenis, a financial services analyst at Morgan Stanley in London. “At the other end we see boutiques and specialists offering mouthwatering returns with alternative assets.”

The top ten firms on the II 300 saw markedly higher demand for alternative assets, ETFs, fixed income and risk-controlled strategies. BGI was managing $14.3 billion in hedge fund assets at year-end 2005, up from $9.5 billion the previous year. “Given the increased competition for alpha and investment insights around the world, we expect this trend to continue,” says CEO Grossman. SSgA, BGI’s close rival, managed $3.9 billion in hedge funds, funds of hedge funds and absolute-return strategies at year-end 2005, up from $3.4 billion a year earlier.

Beyond the top ten, pure hedge fund managers are scaling the rungs of the II 300 as never before. This year the ranking includes 43 hedge fund managers, with about $400 billion in assets. That’s some $100 billion more than a year earlier, when there were 35 hedge funds on the list, and nearly $200 billion more than at year-end 2002, when 32 of them appeared on the II 300.

The biggest hedge fund firm on the list, and one of the fastest climbers, is D.E. Shaw Group, which vaults 56 notches over traditional money managers, to No. 138, as its assets under management nearly doubled, to $20.1 billion, at year-end 2005. Another major mover is takeover artist Edward Lampert’s ESL Investments, which shoots up 44 places, to No. 171, as assets under management have risen 57.9 percent, to $15.0 billion.

Traditional money managers envy those gains, but many remain skittish about handling hedge fund portfolios. “One thing we spend a lot of time researching and evaluating is just how much derivatives exposure is out there in the marketplace and what would happen if we hit a rough patch,” says SSgA’s Flannery. “There’s potentially a lot of systemic risk. If there’s something that keeps me awake at night, that’s probably it.”

Then there is the compensation dilemma. Traditional money managers wonder if they can pay their hedge fund teams much more than their colleagues without destroying their firms’ cultures. And if they don’t pay up, can they get top hedge fund talent?

Legg Mason CEO Mason set his fears aside when he entered the alternative asset business with last year’s acquisition of Permal Group, a fund-of-hedge-fund firm with about $20 billion in assets under management, from Paris-based Sequana Capital. “I was reluctant because of the risks involved,” Mason says, “but I feel less concerned in the hedge fund area because we’re not really now directly managing a manager. We need to be in this space. But I prefer to manage things that I understand well, and I have fears here that I generally don’t have in other areas.”

BGI, GSAM, Mellon and SSgA, among others, are aggressively selling investment products aimed at pension funds concerned about a potential major change in pension accounting rules. In the next year or so, the Financial Accounting Standards Board may decide to follow the lead of the European Union’s International Accounting Standards Board, which since January 1, 2005, has required that pension funds mark to market their assets and liabilities. Currently, U.S. pension funds are allowed to smooth their asset values over several years. Making the change to mark-to-market would tend to worsen funding ratios. As a result, pension funds are looking for investment strategies and products to better manage their liabilities — an approach known as liability-driven investing, or LDI (Institutional Investor, July 2005).

“We are having a large number of conversations on this subject,” says GSAM co-head Peter Kraus. “Its a strong opportunity for us, and it will spawn new products.”

In April, State Street began selling its pooled asset-liability matching solution in the U.S. The product, designed so plan sponsors can match their assets with their liabilities, was launched in the U.K. 15 months earlier. “You’re going to see this validated this year — the shift toward liability-driven investing,” says SSgA’s Flannery.

BGI’s Grossman concurs, “The pension fund crisis has created new opportunities to efficiently and creatively manage assets to reduce risks relative to liabilities — and recent events, including emerging accounting changes, have increased the interest level in such approaches.”

Demand for LDI is notably driving growth in fixed-income mandates. Including multistrategy funds, BGI’s bond assets rose last year by $27.9 billion, to $256.5 billion. Some of the firm’s inflows came from European pension plans focused on liability management. During the 12 months through March 31, the pension legacy units of Legg Mason brought in approximately $50 billion in net client flows, more than half of which probably came from Western Asset Management, estimates Mason. Overseas clients kicked in a substantial share of net inflows.

Although it slips two notches to ninth place, Mellon grew assets under management by 10.5 percent, to $707.7 billion at year-end 2005, mainly on sales of non-U.S. alternative assets. Mellon derived 40 percent of its new revenues from its non-U.S. distribution business in 2005, up from 36 percent in 2004. What’s Mellon’s overseas advantage? “This sounds pretty basic, but it’s having client-service people who speak Italian in our U.K. office serving an Italian bank, for example,” says vice chairman O’Hanley. “You would be amazed at how many people are trying to do it without that.”

For several years running, investors have been clamoring for the international funds of Grantham, Mayo, Van Otterloo & Co., some of whose emerging-markets equity funds have been closed and some traditional products “soft closed” as a precursor to closure. Some of GMO’s strongest inflows were in the equity markets of developed countries in Asia, says Ben Inker, Boston-based chief investment officer for quantitative investments at the firm, which jumps from No. 61 to No. 53.

Founded by legendary value investor Jeremy Grantham in 1977, GMO has flourished in recent years — after it nearly unraveled during the technology-stock-led bull market, when value investing fell out of favor. Grantham and his partners say they have no interest in selling the firm.

But other money managers surely will. “Five to ten years from now, we may be looking at a completely different list of companies than the one we’re looking at today,” says consultant Quirk