Did Market Volatility in 2011 Impact Firm Profitability? - April 2012
Written by Sara Yerkey and C. Meyrick Payne of Management Practice Inc. (MPI)   

mfgovern_april_2012_img1.png    2011 was a year of hesitant investors, a shifting asset mix, and continued volatility, but when all combined, the result was no change in the average firm’s profitability between 2010 and 2011. Although the market recovery that began in 2009 and 2010 continued in 2011, there was slower economic growth than anticipated, partnered with intensifying European sovereign debt and market fluctuations. The greatest decline was recognized with market depreciation in the third quarter. However, these fluctuations were insignificant in comparison to the decline in 2008, and the asset levels returned quickly, allowing average assets to increase between 2010 and 2011.  Management Practice has analyzed the asset trends and resulting pre-tax margins of publically-traded firms. To highlight the quarterly fluctuations of the past four years, the average ending assets of the included firms is presented at right.

     While many firms had higher average assets in 2011, the market fluctuations and economic environment impacted investor confidence. This led to attempted risk aversion, demand for income seeking strategies, and a general rebalancing of assets from equity to lower fee products such as fixed income and money market funds. Additionally, money market funds often experienced further revenue reduction as voluntary fee waivers were implemented in order to maintain positive yields. Although the average assets were closer to 2007 levels, the resulting average basis point fees from lower fee products have caused pre-tax operating margins to remain stifled. The asset mix of analyzed firms had almost 60% of assets in equity products in 2007, shifting closer to 50% in 2011.

mfgovern_april_2012_img2.png     The range of individual firm margins varied in 2011, however the average return after all costs, before taxes and excluding extraordinary items, was 30% of revenue.  In contrast, the advisory margin averaged 53%. The trends of the average advisory and operating margins of investment firms are depicted at left. Because the 2011 market fluctuations failed to cause average assets to drop below 2010 ranges, the revenues remained relatively constant for the year and allowed firms to avoid operational expense reductions and incurring one-time restructuring fees. The 2010 and 2011 margins would have had a more significant increase compared to 2009, but in 2009 many firms recognized one-time extraordinary items, reducing the expense component of their margins to adjust for the lower revenues. If these items were included, the 2009 margins would have been significantly lower.

     2011 margins were also impacted by bonuses associated with improved performance in 2010 and 2011 as well as the ever-increasing percentage of assets flowing through distribution platforms and the expenses associated with these assets.

     In addition to understanding the drivers and trends of profitability, a purpose of this analysis is to provide trustees a benchmark with which to evaluate profitability. One of the most important functions performed by mutual fund trustees is the annual review of investment management arrangements.  A possible factor in this review is the analysis of the investment manager’s profitability. The Jones vs. Harris case has reinforced the contract renewal process that has been conducted for the past 30 years, and has emphasized that the assessment of the advisor’s profitability remains a necessary step.

     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 individual fund review.   Fund profitability is typically based upon the advisory fees and the corresponding expenses alone, whereas the complex-wide operating margin is measured on the basis of all investment management activities, including marketing and shareholder services.

     MPI’s analysis of advisory margins shown above corresponds to those referred to in the Gartenberg line of cases, where a “guideline” margin of 77% was established. In our 2011 analysis, we found that the average profitability on the advisory contracts was equal to 2010 at 53% and the operating margin for those companies was 30%.

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     The complete analysis including ten years of operating and advisory margins, underlying participant detail, product and asset trends and profitability drivers are available by contacting Management Practice.