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Special Report

At Odds: Fund Companies and Their Two Masters

Are fund shareholders losing out to fund company stockholders?

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At Morningstar, we frequently hear managers and analysts who used to work on the sell side (at brokerage houses) mention how happy they are to work on the buy side (at asset managers), where conflicts of interest are much smaller. Whereas Wall Street historically wanted analysts to function as investment bankers first, and analysts second, that wasn't the case in money management. There, analysts typically recommended only a handful of the companies that they covered. In short, they were doing research--not sales.

But that's not to say the fund industry doesn't have conflicts. Mutual fund companies embody an inherent tug of war between two sets of shareholders. On the one hand are the holders of the fund company stock. On the other are the mutual fund shareholders.

Shareholders at Odds
Consider the following: Fund shareholders benefit from low fund fees; company shareholders benefit from increased profitability when fund fees are high. Fund shareholders benefit when funds are closed before they get too big; company shareholders benefit when fund assets continue to grow. Fund shareholders have lost millions in gimmicky funds, such as those that invest in the Internet; company shareholders have made millions off those same funds. To be sure, treating fund investors well and acting as long-term stewards of capital is the best way to ensure long-term profitability, but conflict arises when fund companies go for big short-term profits.

To judge by the profitability of fund companies and the performance of their stocks, the tug of war clearly favors company shareholders. It's no accident that fund managers at high-profile shops such as Ariel, Gabelli, Oakmark, and Tweedy, Browne love to invest in their own industry. These managers favor companies that throw off tons of free cash flow, and asset managers are cash-flow machines. They've also delivered super returns for shareholders. Over the past decade, the average money management stock has returned a stunning 16.63% per year through mid-2003, outpacing the S&P 500 by more than 6.50 percentage points annually!

But at a time when many fund shareholders are smarting from sharp losses suffered during the bear market, the disparity between their returns and those experienced by fund-company stockholders is especially stark. True, many fund companies have lost assets and seen profitability slide recently, but they've held up remarkably well given the extent of the downturn. Equally important, those that have attracted assets haven't felt a pressing need to cut expenses.

For example,  Gabelli Asset Management's (GBL) three largest offerings-- Gabelli Asset (GABAX),  Gabelli Growth (GABGX), and  Gabelli Value (GABVX)--each with more than $1 billion in assets, charge an egregious 1.36%, 1.40%, and 1.40%, respectively. Those fees fuel operating margins in the 40% range that have helped deliver annual gains of more than 16% to Gabelli Asset Management stockholders for the trailing three-year period through Aug. 1, 2003. (To be sure, both fund shareholders and stockholders can't be happy about CEO Mario Gabelli's 2002 salary, which exceeded $30 million.)

Gabelli Asset Management is the rule rather than the exception, which raises the question: Can fund companies fairly serve both their stockholders and shareholders in their funds?

To investigate, we examined the profitability of fund companies over the past few years--we looked at their net margins, returns on investments, and other important measures of profitability. We also measured stock performance to see just how well stockholders were doing. Next, we calculated how shareholders in their funds were doing by taking a weighted average trailing three-year return for each fund family and a weighted average expense ratio for each family's funds. (This allows us to assign greater importance to the larger funds than we would in a straight average.)

A Stacked Deck
We recognize that investors in a firm's stock take on significantly more risk than do investors in a fund, and therefore expect to be compensated more highly, yet nonetheless, the spread between the two groups' returns is stark.

Among the larger fund companies, the most significant disparities between the relative standing of fund shareholders and fund-company stockholders exist at some load fund shops. Part of the divergence can be explained by the vast sales networks that these firms must support, but the width of the chasm is startling.

 Eaton Vance (EV),  Alliance Capital Management Holding (AC), and  Federated Investors  (FII) are cases in point. Shares of Eaton Vance and Federated have enjoyed incredibly strong runs; Eaton Vance's shareholders have enjoyed annual gains of approximately 25% for the trailing five-year period through Aug. 1, 2003, while Federated stockholders have seen their shares appreciate 19.8% over the same period. The firms' shareholders enjoy net margins well above 20% and a return on equity greater than 30%. (With profitability like that, it's easy to see why the stocks have soared.) Owners of Alliance Capital's units haven't been quite as lucky, but they're not hurting. Despite that the firm's business is often mentioned in a less favorable light than its peers', its units have nevertheless jumped more than 15% over the aforementioned period. Here again, its stockholders have been rewarded for investments in a firm with net margins in excess of 20%.

But investors in the firms' funds haven't done nearly as well. For the trailing five-year period through Aug. 1, the weighted average return of all Eaton Vance funds is just 0.08%. For Federated, that number is 3.08%, while it's 2.29% at Alliance. That's partly because these firms' funds aren't cheap: Despite a large number of fixed-income offerings, Eaton Vance's weighted average expense ratio is above 1.40%, while Federated charges approximately 1.17% on a weighted average basis. Alliance, meanwhile, has a weighted average expense ratio of more than 1.60% (see the table below for more information).

 Asset-Weighted Expense Ratios ( % )
 (includes both bond and stock funds)
Alliance Capital Management (AC) 1.66
American Funds 0.77
Dodge & Cox 0.53
Eaton Vance (EV) 1.42
Federated Investors (FII) 1.17
Fidelity 0.79
Gabelli Asset Management (GBL) 1.42
MFS Investment Management 1.34
Merrill Lynch & Co.  (MER) 1.19
T. Rowe Price Group (TROW) 0.82
Putnam 1.16
Vanguard 0.25

That isn't to let the no-load shops off the hook. Like the aforementioned Gabelli funds, large offerings such as  Strong Growth (SGROX),  RS Emerging Growth (RSEGX),  Royce Low-Priced Stock (RYLPX),  Marsico Focus (MFOCX), and many others are priced higher than they should be. While it's true that some surcharge is to be expected to service the large number of small retail accounts that funds often have to contend with, the comparison with lower fees on institutional products is stark.  

Mismatched Power
The expense structure of mutual funds is designed for maximum profitability for the stockholders, not fund shareholders. The returns to each group show this. More importantly, this setup creates incentives to leave funds open too long, maintain expenses at substantially higher levels for mutual funds than institutional accounts, push funds that are on short-term hot streaks, and introduce new funds after asset classes have run.

To be sure, there are fund companies, public and private, load and no load, that realize the best way to serve their stakeholders is to serve fund shareholders. T. Rowe Price, Fidelity, and the American Funds charge just between 0.75% and 0.85% on a weighted-average basis. Dodge & Cox is lower at 0.53%, and Vanguard is even lower at 0.25%. And these firms aren't hurting.

But for change to occur across the industry, a few things need to happen. Among the most pressing issues are the lack of independent boards, poor disclosure of costs, and a lack of fund-manager incentive disclosure. 

The first problem stems from the fact that fund boards aren't as active as they need to be. Not only is it time to appoint more independents to fund boards, but larger fund shops must also curb the number of boards on which an individual can serve. Currently, individuals can serve on scores of fund boards, so they aren't as prepared as they ought to be; in such situations fund companies set the agenda--board members rarely do. In addition, board members don't have much at stake in the funds they govern--a key difference between fund and stock boards.

Costs are another gnawing issue, particularly because fund companies steadfastly refuse to disclose such expenses as soft-dollar payments and estimates of trading impact. With regard to the former, possibly the only credible argument for them relates to IPO access, but it's a weak one. Finally, it's important to know the way a manager is compensated because it can significantly affect how a fund is run. If a manager's pay goes up based on the assets in the fund, there's less incentive to close ballooning funds.

Addressing these issues may not solve the mismatch in power between fund owners and fund-company owners, but it certainly gives fund shareholders a more level playing field. While the industry is unlikely to emulate the Vanguard model--in which the owners of the funds own the fund company, too--fund boards must be more active in guarding fund shareholders' interests in relation to those of stockholders. One group need not benefit at the expense of the other.

This article originally appeared in the Aug. 21, 2003, issue of Morningstar Mutual Funds. Click here for a product description and subscription information.

Kunal Kapoor does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.