Perhaps the most important function served by mutual fund directors is the annual review of investment management arrangements. One factor in this review is the assessment of the investment manager’s profitability.
Each year MPI conducts a survey of profitability of publicly-owned investment management companies which provides independent directors a quantitative benchmark to assist in their discussions regarding the reasonableness of the profitability of the funds they govern.
The chart which follows shows the range and average return on revenue earned by 16 public companies over the past twelve years. While the range of profitability has varied considerably, the average has remained at about 50%, despite the market performance fluctuations since 2005 and the substantial change in distribution models and fee structures, and the product mix shift toward lower fee and indexed products. Individual firms have realized different trends as a result of varying degrees of responsive expense structures.
While there is no hard and fast rule for determining whether an adviser earns an unreasonable profit (high or low) on a fund, a thorough review process and adequate documentation will help demonstrate that directors have fulfilled their responsibilities as guardians of the fund shareholders’ interests. Part of this process is to ask questions of Management to fully understand, and have comfort with, the drivers of profitability, any changes or exceptional items, and any anticipated significant changes in profitability.
Court rulings also provide additional guidance and benchmarks to fund boards their counsel on both advisory and total investment activities. One court found in the early 1980’s that, after considering all relevant factors, an adviser’s pre-tax profit of 77% return on advisory activities (including shareholder and administrative) was not unreasonable under the circumstances.
Fund directors should understand the profit on advisory activities in the context of complete business operations, as lower margins typically exist on shareholder servicing, and losses often come from distribution and marketing activities. The chart below depicts what a typical firm’s break-down of business lines may look like:
Significantly lower than the advisory profitability calculations, the overall profitability for all investment activities, including shareholder services and distribution, of the 18 public companies tracked in MPI’s 2016 study ranged between 43% on the high side to 17% on the low side with an average of 31% return on revenue.