May 31, 2007

Is the Price of Money Managers Too Low?

Gur Huberman examines why competition hasn't eliminated profits for money managers, and why mutual funds are still priced well below the value of their profits.


There are hundreds of mutual fund families. Barriers to entry are low. And little capital is tied up in the business. These factors suggest that the industry is competitive and that its producers should therefore have low if not zero profits. But how does the market set the price of these expected future profits? In other words, how does the market price the equity of established money-management firms?

Consider a firm that manages a short-term-bond mutual fund, or even a riskier stock fund, and charges a fee at the end of each year equal to a fraction of the assets under management. The firm’s revenues pay for asset gathering, servicing and portfolio management, and for income taxes on profits. The rest goes to the firm’s owners. Simple back-of-the envelope calculations show the pretax and after-tax profit margins are 35 percent and 20 percent, respectively, and money-management firms should be priced accordingly. (See box for details of the calculations.) Such profitability seems difficult to reconcile with an industry that is highly competitive.

In fact, money-management firms are priced at 1 percent to 4 percent of assets under management. It is tempting to explain away the discrepancy between the theoretical and actual price by citing the risk that any money manager may lose most or all of the assets under management for a variety of reasons, such as abysmal performance. But the formula also applies to incumbent money managers collectively, not just to individual money managers. Their collective risk appears negligible.

Calculations

Consider a firm that manages a mutual fund and charges a fee at the end of each year equal to a fraction c of the assets under management. Assuming that it initially manages $A, that the annual rate of interest is fixed at R and that clients neither add nor withdraw money from the fund, the stream of income that the management company will receive is: A(1 + R)c at the end of the first year, A(1 + R)2 (1 - c)c at the end of the second year, A(1 + R)3 (1 - c)2c at the end of the third, etc. At the discount rate R, the present value of this stream is A minus the value of the assets under management.

Other explanations suggest that current fees and profit margins are not sustainable in the long run and that competition will shrink them. Since prices reflect expectations of future profits, these explanations cannot be ruled out, but they entail ominous predictions for the money-management industry. And they beg the question: Why hasn’t competition eliminated these profits by now?

Money managers’ profits are derived from the fees they charge. In the absence of compelling evidence that money managers deliver excess returns, their clients should pay close attention to these fees. Indeed, straightforward calculations show that typical fees and performance are likely to result in substantial wealth dissipation, especially for long-term, buy-and-hold clients.

This issue is somewhat different for retail and institutional products. On the retail level, customers may pay little attention to fees because they seem small. It may even be the case that cutting fees to bolster performance is a money-losing proposition for a money manager. But, at least formally, each fund has trustees who are supposed to look after the interests of those whose assets are managed by the fund, not the interests of the firm that manages the assets. Why do these trustees not cut the fees and thereby also the managers’ profits? Probably because they owe their positions to the fund managers, and tend to act in accordance with the managers’ interests.

In defined contribution retirement plans such as 401(k)s, plan sponsors contract with fund families to offer their funds to participants. Incentives for individuals to participate are strong, thanks to their preferential income tax treatment and often also to the sponsor’s matching contributions. One might think that sponsors would negotiate the fees down to (almost) eliminate the profits of the money managers, but the fees charged to fund holders in 401(k) plans are often the same as those charged to other retail customers. The overlooking of the seemingly small fees by retail customers offers at least a partial explanation of the profitability of funds that cater to retail customers.

However, such arguments should be less relevant for institutional money management, which is often performed by the same organizations that manage money for retail customers. Presumably, institutional clients are savvier than retail customers and, negotiating from a strong position, can bargain down the management fees to their competitive levels — the point at which institutional money management will earn (almost) no profit. However, they don’t; even with institutional clients, money managers seem to charge fees at higher than the competitive rate.

Even so, the market prices the business of money management well below what it appears to be worth — a price that would reflect the rich fees and high profit margins of the money managers.

Gur Huberman is the Earle W. Kazis and Benjamin Schore Professor of Finance and Economics at Columbia Business School.

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