Mutual Fund Companies Often Make Better Investments Than The Funds They Manage

It may seem unfair, but over the past 20 years you would have been far better off investing in the provider than the service.  Over the last decade, for instance, T Rowe Price (TROW) the stock has returned an average of 12% per year as of 1/31/08.  The Vanguard 500 Index fund (VFINX), by contrast, has returned barely 4% per year over that time period, and it was in the top half of all large-cap stock mutual funds.  The T Rowe Price example isn’t an anomaly, however.  Over the decade ending December 31, 2006, the returns of the largest and most established mutual fund companies have routinely beaten the returns of their fund offerings by a factor of 2 or even 3.

Returns of Mutual Fund Companies vs the Stock Funds They Manage

Company	5-year Avg. stock performance	5-year Stock-fund Avg. return	10-year Avg. stock performance	10-year Stock-fund Avg. return
Franklin Resources	27.14%	11.05%	18.15%	9.22%
Legg Mason	24.29%	7.06%	26.76%	7.54%
T Rowe Price	22.34%	11.02%	16.67%	9.34%

Source: Marketwatch

The Economics of Money Management

This out-performance is no surprise considering the favorable economics of the industry.  If you’ve ever owned a mutual fund, you know mutual fund companies are paid based on a percentage of assets known as the expense ratio.  These fees can run anywhere from 0.1% for index fund to well over 2% for some foreign on more exotic asset classes.  Let’s say they average is 1% just to make things easy.  That means a fund with $10 billion in assets generates $100 million in fees every year.

The beauty of this business model is that the incentive to perform well is built-in to the compensation system.  If a stock mutual fund returns 15% for its shareholders next year, it’s just given itself a 15% raise.  Actually, it’s quite likely given itself more than a 15% raise, which I’ll explain in moment.  To make things even better, solid fund performance attracts new investment dollars.  It’s a double whammy.  Because of this, it’s very easy to see how fund companies can grow earnings far quicker than the overall market during a bull market.

A Levereged Bet On The Market

As I alluded to above, managing money involves a lot of operating leverage.  That is, expenses tend to rise much slower than revenues.  A fund that doubles its assets under management will not see anywhere near a doubling of its expenses.  Consider the above example in which Fund Company A grosses $100 million in fees during year one and whose net operating margin works out to 30%, yielding $30 million in profit and $70 million in expenses at the end of year one.  Now assume its mutual funds return an average of 15% next year.  At the end of year two, Company A will now be grossing $115 million per year ($11.5 billion x 0.01);  however, its expenses will have grown by only 10%.  Thus, at the end of year two, net operating profits will be $38 million ($115 million revenue - $77 million expenses), or an almost 27% increase.  Furthermore, Company A’s funds would probably have received additional investments during the year in response to its fund’s solid performance.  All told, Company A’s earnings could rise 30% or more as opposed to a 15% gain for the wider market.  When you grow earnings by 30% a year over the course of 3 or 4 years like most money managers have done lately, it’s easy to understand the source of their high stock returns.

Company A Income Statement (in millions)

Company A	Year 1	Year 2	Year 3	Year 4
Revenue	$100	$115	$132.25	$152.09
Expenses	$70	$77	$84.7	$93.17
Earnings	$30	$38	$47.55	$58.83
Operating Margin	30%	33%	36%	39%

As you can see, operating profit margins will continue to expand as long as Company A’s mutual funds continue to net positive returns.

Leverage Cuts Both Ways

Unfortunately, this phenomenon works against you on the downside.  Just as good performance results in asset inflows, poor performance results in asset outflows.  This acts as a double whammy since both negative fund returns and investor redemptions lower assets under management and thus revenue.  Because of this, you should probably wait until a pretty substantial bear market to initiate a position in an asset manager to minimize your downside and maximize your upside.

Your Ticket To Above-Average Returns

Over the long run, asset managers should continue to deliver above-market stock returns albeit with much greater risk than the broad market.  If the long-term trend in the stock market is up and the base economics of the industry don’t change too much, you will almost always do better buying the mutual fund company than the funds they manage; however, you should be prepared for huge amounts of volatility in your portfolio due to its leveraged nature.  The most logical way to take advantage of the economics of this wonderful industry without too much added risk is to invest 90% of your portfolio in index funds and the remaining 10% in two or three of your favorite asset manager stocks and maybe one or two promising stocks in other industries.