Exceptional Market and Asset Growth So Why Not Corresponding Industry Profit Margins?
Written by By Sara Yerkey of Management Practice Inc. (MPI)   
     2012 was a year of fantastic market performance, even amidst slow economic growth. The S&P returned 16% and the aggregate bond index over 4%. So as the year-end earnings reports were announced, why didn’t we hear margins jump or at least climb for asset managers?

     The answer was not due to fickle investors. There was not only asset growth due to market appreciation, but investors responded to the positive markets with net inflows to open-end, long-term funds. But however positive the equity markets proved to be, investors have not yet been able to gain confidence and shake a more conservative approach, and bonds continued for the 6th consecutive year to attract more flows than equity and alternative funds.april_2013_bill_2_img_1.png This product shift and resulting lower fees on assets is one of the contributing factors to the resulting margins in 2012. Management Practice has analyzed the asset trends and resulting pre-tax margins of a sample of publically-traded asset management firms, with the trend in product shift presented at right.

     Lower average fees were also a result of not only inflows to fixed income products, but ETFs, and firms offering inexpensive actively managed assets. Of the sample firms, an increase in average assets did not equate to enough additional revenue to overcome the shift in lower average fees collected and the increase in expenses as a percentage of revenue.

     Two of the largest expense items incurred by asset managers, compensation and distribution, both increased as a percentage of revenue in 2012. Although portions of compensation are fixed, often the greatest component, bonuses and sales commissions, were significant because of the performance in 2011 and 2012. Distribution continues to have an increasing impact on profit margins for multiple reasons. Not only are there an ever-increasing percentage of assets flowing through distribution platforms, but firms are exploring multiple channels of distribution to remain competitive and incurring the associated costs. Also, distribution expenses are often variable to assets. So as assets increase, but the average fee collected on these assets declines, distribution fees eat further into firm profitability.

     The impact of the increased average assets, the lower average fees, and the higher average expenses as a percentage of revenue had the impact of slightly lowering the average advisory april_2013_bill_2_img_2.pngand operating margins of the sample firms between 2011 and 2012, as shown on the chart to the left. The range of individual firm margins varied in 2012, however the average return after all expenses, before taxes and excluding extraordinary items, was 28% of revenue. This is down from 30% in 2011, in spite of the almost 5% increase in average assets. While these margins are presented excluding any extraordinary items, 2012 did see an uptick in these events. In contrast to 2009 when firms were incurring extraordinary restructuring expenses due to asset loss, 2012 events were more often the result of mergers, acquisitions or fund launches.

     Similar to the operating margin, the average advisory margin was 52%, down from 53% in 2011. The advisory margin consists of 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.

     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 and emphasized by the Gartenberg ruling is the annual review of investment management arrangements. One element in this process is measuring and monitoring profitability on a fund by fund basis. An additional possible factor in this review is understanding not only the advisory contract, but also the impact of distribution and other operations on the investment manager’s profitability.

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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.