Supreme Court Confirms Need for 2009 Profitability Benchmarks
Written by C. Meyrick Payne and Sara Yerkey of Management Practice Inc. (MPI)   

     The most important function performed by mutual fund trustees is the annual review of investment management arrangements.  One of the more complex and potentially confusing factors in this review is the analysis of the investment manager’s profitability. The recent ruling in the Jones vs. Harris case has reinforced the contract renewal process that has been conducted for the past 25 years, and has emphasized that the assessment of the advisor’s profitability remains a necessary step.

     The procedure trustees follow to review profitability is critical. A thorough review process and adequate documentation will help demonstrate that trustees have fulfilled their responsibilities as “watchdogs” of the interests of the shareholders.  The courts have clearly rejected the Calvinistic notion that too much profit is in itself a cause for condemnation. There is no hard and fast rule for determining whether an adviser earns an unreasonable profit from a fund. One court found that, after considering all relevant factors, a fund’s pre-tax profit of 77% return on revenue was reasonable under the circumstances.

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     Nonetheless fund trustees should have some benchmark against which to evaluate profitability. Over the past seventeen years, MPI has tracked the pre-tax profit margins of publicly traded companies significantly engaged in mutual fund management. Not surprisingly the range of profit margin has varied, although the average return after all costs, but before taxes, is usually about 30% of revenue as shown in the exhibit. 

     MPI’s analysis in 2009 concluded that while assets had returned by year-end from the dramatic decline in 2008, both the fall in assets and the rebound had occurred in the latter parts of the corresponding years, leading the average assets, total revenues and overall margins of 2008 to be higher than 2009. Additional contributing factors to lower revenues and resulting margins were a drop in performance fees, additional fee waivers and an asset mix shift to money market and fixed income products, resulting in lower average advisor fees. 

     With this said, firms realized asset growth and corresponding margin improvement as 2009 continued, as can be seen in the table below. With on-going strong market performance in the first quarter of 2010, operating margins should continue to stabilize.

supreme_court_confirms_need_2009_img2.jpg     Measuring and monitoring profitability on a fund by fund basis is also important because the trustees represent shareholders of each individual fund and because the Gartenberg ruling emphasizes the importance of fund review.   Fund profitability is typically based upon the advisory fees and expenses alone, whereas complex profitability is measured on the basis of all investment management activities, including marketing and shareholder services.

     Imbedded within the profitability measures are inevitably allocations of costs common to numerous funds. These include corporate overhead as well as services such as transfer agency, custody, fund accounting, and administration. Fund trustees need to understand the allocation methodologies and confirm that they are appropriate.

     This exhibit is MPI’s calculation of the average advisory fees corresponding to the previously listed operating margins. These calculated fees are the margins which are comparable to the 77% referred to in the Gartenberg case. For the year ended December 31, 2009, we found that profitability on the advisory contract had declined from an average of 52% in 2008 to 49% in 2009 due largely to the lower revenue resulting from lower average assets and product shift.

supreme_court_confirms_need_2009_img3.jpg     Assessing profitability is one of the most sophisticated judgments a mutual fund director makes. As a result boards often retain an independent third party to develop appropriate benchmarks, to understand the different levels of profitability, and to attest that the allocations are done on a consistent and appropriate basis.

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      Management Practice Inc. is a specialized consulting firm based in Stamford, Connecticut, and provides governance, economic, and business advice to mutual fund boards.