An Uneasy Rebound for Fund CompaniesDavid Bogoslaw
To a great extent, all actively managed equity mutual funds have benefited from the stock market rally over the past three months. Fund inflows have rebounded dramatically and stock prices of the asset management companies themselves have roughly doubled since Mar. 9. But enthusiasm toward stocks has cooled in the past two weeks as the markets more carefully weigh the considerable obstacles that the U.S. economy needs to surmount before it can return to health.
While the pace of money flows into equity mutual funds seems to have picked up in June from April and May, that's probably a bearish sign for stocks, according to TrimTabs Investment Research in Sausalito, Calif. That's not only because the amount of cash on the sidelines has been reduced, but because mutual fund investors tend to invest heavily in the late stage of rallies, says Conrad Gann, president of TrimTabs.
Daniel Fannon, an analyst at Jefferies (JEF) in San Francisco, sees all mutual fund managers benefiting from the positive momentum in equity markets of late. The May data for net inflows to mutual funds show that when investors piled back into equities as the rebound from early March continued, they didn't make much effort to distinguish between good and bad asset managers, he says.
"That's not sustainable, even if [equity] markets are flat from here" over the next six months, he says. "People will be choosey with where they're putting their money. There will be greater focus on relative performance, on one-, three-, and five-year numbers."
second-quarter operating margins
Fannon expects certain asset managers with superior returns year-to-date to gain market share as investors start to reward better performance. Among the likely winners, Invesco (IVZ) stands out as a result of how well it performed on a relative basis in 2008 and even in the early months of 2009. Waddell & Reed (WDR) should attract new money, given the superior returns earned by its Ivy Asset Strategy Fund (WASAX) and Ivy Global Natural Resources Fund (IGNAX) so far this year. Janus Capital (JNS) has a broader range of funds that have done well this year and there are some T. Rowe Price (TROW) funds with impressive returns as well, he adds.
Another way to differentiate these stocks will be to compare operating margins in second-quarter earnings, says D.J. Neiman, an analyst at William Blair in Chicago. "The firms have done head count reductions of 10% to 12% to right-size their expense bases to current market reality levels and revenues levels," he says. "We'll see how quickly operating margins can snap back since moving from the lows" earlier this year, he says.
Growth in the mutual fund industry and among individual publicly traded companies will come mostly from investors outside the U.S. over the next decade, he predicts. That should benefit Invesco, Franklin Resources (BEN), and BlackRock (BLK), all of which have a bigger portion of their assets coming from non-U.S. investors.
Most of the gains in assets under management that have resulted from stock market appreciation are expected to fall directly to the asset managers' bottom lines in the second quarter, analyst Kenneth Worthington said in a JPMorgan Chase (JPM) outlook report for the second half of 2009, published in June.
Invesco's money market funds gained
Invesco is Worthington's favorite pick of the group over the next six months, thanks to the uptrend in stocks and strong appreciation in the Canadian dollar and the British pound. With foreign markets recovering faster than the U.S. market, Invesco's greater international exposure should be a plus, even apart from the currency effects, he said. He expects Invesco's management to be on the hunt for ways to increase earnings in the current market, which even in a flat market should boost the firm's earnings growth above that of its peers and drive up its price-to-earnings multiple.
Invesco's ability to gain market share for its money market funds in a declining money market industry also makes the company attractive, according to Credit Suisse (CS) analyst Craig Siegenthaler. In a June 10 research note, he cited $5.4 billion of net inflows in May into Invesco's money market funds.
The prospect of a weaker U.S. dollar makes Franklin Resources a good bet, since it is one of the companies with the most leverage to a weakening greenback, Credit Suisse said. Non-U.S. clients generate 24% of its assets under management, but Franklin has said that over 90% of its operating income is U.S. dollar-based.
Much of Janus's estimated 23% asset-weighted return in the second quarter has come from its foreign-asset funds such as the Orion Fund and the Contrarian Fund, Credit Suisse said. Waddell & Reed's returns so far in the second quarter have benefited from the firm's Global Natural Resources Fund, which has returned 42% since Apr. 1.
ETFs: lower fees, better tax impact
Eaton Vance (EV) merits an outperform rating from Credit Suisse, in part because of how much its tax-advantaged strategies have contributed to its 8.8% asset-weighted return since Apr. 30.
The recent rally has helped restore some confidence in actively managed mutual funds, but the asset managers that run them face big challenges down the road. Growing awareness among retail investors about how much they are giving up in fees to mutual fund managers is boosting demand for exchange-traded funds, which have much lower fees and a more favorable tax impact from capital gains distributions.
BlackRock, with its $13.5 billion acquisition, announced on June 16, of Barclays Global Investors, Barclays' investment unit, will become the world's biggest money manager. That could speed adoption of ETFs by other asset managers if they see themselves as losing ground to BlackRock. ETFs have been aggressively gaining market share for the past 10 years and the general underperformance of actively managed funds with respect to indexes last year only added to ETFs' popularity.
A key challenge for actively managed funds in the future will be responding to competition from ETFs within defined benefit plans. Sponsors of 401(k) plans are already under pressure from Congress to improve their reporting to plan participants of performance, expense ratios, and fees for funds within retirement plans.
ETFs will force mutual fund fee cuts
"I believe eventually ETFs will find their way into 401(k)s," says Tom Lydon, editor of the Web site ETFTrends.com. He estimates that 401(k) plan participants would save 1% of their portfolios' value by investing in low-cost ETFs instead of actively traded funds. And because ETFs as a category are well-diversified—investing more than 50% of their assets outside the U.S.—they would better serve participants in 401(k) plans, given the expectations for speedier recoveries from the recession by some foreign economies and their larger future growth prospects, he says. The average 401(k) plan has about 12% of its assets allocated outside the U.S., he says.
Over time, competition from ETFs will put more pressure on mutual fund fees, says Fannon at Jefferies. To date, ETF growth hasn't come at the expense of mutual funds because there's been enough growth for all asset managers, But given the fact that mutual funds charge fees more than double the average fee ETFs charge, "there is room for fees to come down within mutual funds" without doing serious damage to mutual funds' operating margins, he adds.Vanguard offers a selection of ETFs while Pimco, a unit of Allianz (AZ), has launched one that holds short-term Treasury bonds and Charles Schwab (SCHW) has a handful in registration that are likely to be rolled out by the end of this year, says Lowry. He predicts T. Rowe Price will offer ETFs in the future as demand picks up and says the firm is already structured to develop them internally.
As ETFs take advantage of a wider array of distribution channels—from high net worth investors to certain broker-dealer networks—they're likely to take more market share, although it remains to be seen how that evolves, says Fannon at Jefferies.
Despite the lower fees, "performance is the best differentiator over time," he says. "No matter what your product is, you should be able to charge a premium fee for a superior product. Like this year, active managers are putting up a solid rebound as far as performance is concerned. That's the best way for these [companies] to keep their competitive position over time."