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Funds are Good. Are Fund Companies Better?
Investment management is the professional management of various assets or securities (real estate, stocks, bonds, etc.) to meet specified investment goals for the benefit of investors. There are a wide variety of open-end (mutual) and closed-end funds out there for investors to sift through, ranging from mundane money market trusts to risky high-yield bond funds. However, we think there may be an even better, albeit more unconventional, alternative to investing in funds: buying the shares of the asset management firms. After all, the equities of investment managers have generally produced better returns over the long haul than the products they offer.
We like the fund companies, mostly due to their business models. Indeed, asset managers tend to make money in good years and just so-so years, since they charge service fees on assets under management (AUM). Moreover, the management fees charged are usually proportionate to the performance of the underlying portfolio or the fund shares, so returns generally advance at a very strong clip during bull markets. The larger players in the industry, like AllianceBernstein Holding (AB), Legg Mason (LM), BlackRock (BLK), Franklin Resources (BEN), and T. Rowe Price Group (TROW), all have economies of scale on their side, too. This enables them to funnel most, if not all, of the additional service fee income directly to their bottom lines, or it allows them to support geographic or product expansion programs.
However, as we have seen in the past two years or so, the aforementioned trend can quickly reverse itself. Indeed, the equities of asset management firms can get hit especially hard during recessions and/or bear markets, since profits tend to decrease rapidly during these times. More often than not, the slide is due to reduced service fee income. When the broader equity, bond, and/or real estate markets are in tailspins, the prices of the underlying assets or fund shares most likely fall. Since the management fees charged by the fund companies generally correlate directly with the performance of the portfolio or fund shares, the bottom line deteriorates rapidly.
There is also another phenomenon that tends to occur during bad times, which creates a double whammy. As the prices of mutual fund shares (or the broader equity, bond, and/or real estate markets) stumble, investors tend to jump ship quickly. They withdraw some or all of their money, which reduces the amount of AUM. This, in turn, decreases the amount of service fee income generated.
Despite (or owing to) the group’s recent woes, we think now is the time to buy. Many of the major players in this industry have faltered over the past two years or so. Indeed, shares of Legg Mason and AllianceBernstein have both lost more than 50% of their value since the collapse of Lehman Brothers back in September, 2008, mainly due to the lackluster performance of the broader equity markets during this time frame. Still, we think there is lots of room for the sector to grow. The U.S. market is mature by now, but there is still plenty of space to expand overseas. There are a lot of countries in Eastern Europe and in the Asia/Pacific region that present the same opportunity for asset managers that the U.S. provided only a few decades ago. In this regard, we like AllianceBernstein, BlackRock, and Legg Mason. All three have considerable presence abroad, and can trace a hefty amount of AUM to foreign sources. BlackRock has fared much better in the wake of the credit crisis. than its two counterparts, and we still like the company’s long-term prospects. It has a tremendous amount of capital in its coffers, and holds a dominant position in the domestic marketplace.
Investors looking for a safer selection may want to look elsewhere, though. The industry is highly regulated by the U.S. government, and any number of legal or legislative actions could hurt asset managers’ share prices. Still, we think T. Rowe Price and Federated Investors (FII) are good selections for conservative investors. The former is one of the biggest players in the domestic 401(k) market, and is slowly bolstering its international presence. The latter offers mostly money market funds, which are generally deemed to be one of the safest investments out there.
Finally, we think investors should note that unlike most industries, the larger asset management companies have historically outperformed the small-cap ones. We think this is due to their ability to use economies of scale to their advantage. The niche players do not have the ability to diversify their product offerings or expand overseas, either, which has likely hurt profits. That said, we think Affiliated Managers Group (AMG) and Eaton Vance (EV) are worth a look.