Profitability Benchmarks for Contract Renewal - April 2009
Written by 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 most complex and potentially confusing factors in this review is the analysis of the investment manager’s profitability. In the past year the Jones vs. Harris case has perplexed many a mutual fund lawyer in that it may change the way in which the contract renewal process has been conducted for the past 25 years. However, there has been no final resolution and, until the case is decided by the US Supreme Court, the assessment of the advisor’s profitability remains a necessary step in the contract renewal process.

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, an adviser’s pre-tax profit of 77% return on revenue was reasonable under the circumstances.

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 considerably, although the average return after all costs, but before taxes, is usually about 30% of revenue as shown in the exhibit below.  Not surprisingly the range of profitability varies over the years; in 2008 the bottom of the range was 9% and the top was 41%.

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Many mutual fund trustees believe that profitability should be measured on both a fund by fund basis and on a complex-wide basis. Fund by fund profitability is important because the trustees represent shareholders of each fund and because the Gartenberg rules specify that fund-by fund review is important.  Generally fund by fund profitability is based upon the advisory fee alone, whereas overall profitability tends to be measured on the basis of overall investment management activities, including marketing and shareholder services. Needless to say with both fund by fund and overall profitability there is considerable reliance upon the allocation of overhead, which is necessarily judgmental.

Advisory fee profitability on a fund by fund level is typically simply the difference between the advisory fee paid by the fund to the manager and the manager’s expenses related to managing the fund. Using this formula trustees can compare a fund’s profitability to that of other funds, illustrating that certain fund types are more or less profitable to manage than others. For the year ended December 31, 2008, we found that profitability on the advisory contract alone had declined from an average of 55% in 2007 to 51% in 2008.

The most important factor of MPI’s analysis in 2008 was that overall profitability and assets under management declined dramatically as the 2008 year progressed. For example in the first quarter the overall profitability, before tax, of the 13 companies MPI analyzed was 32%, compared to 26% in the fourth quarter, and assets for these complexes had declined by an average of 22%.

  Overall Profitability and Asset Decline

  ROR*
Assets**
 First Quarter
 32% 4%
 Second Quarter
 30%  1%
 Third Quarter
 32%  -13%
 Fourth Quarter  26%  -14%
 Overall 2008 Year
 30%  -22%

* Return on Revenue  ** Quarterly Change  

MPI has typically found that small funds (generally under $120 million in assets) are unprofitable as are funds within two years of inception whatever their asset size.

 

Imbedded within the profitability measures are inevitably allocations of costs common to several funds. These include corporate overhead as well as services such as transfer agency, custody, fund accounting, and administration. Any one of these costs may be allocated. Fund trustees need to understand that these allocations are appropriate. Generally there are five bases of allocation: (1) asset based, which tends to make the largest funds less profitable, (2) revenue based, which takes the assets and multiplies by the advisory fee, which tends to allocate even more expenses to the largest equity funds, (3) time based, which requires keeping some sort of time-expended records, (4) cash flow based, which tends to allocate costs to those funds which have the greatest sales and redemptions, and (5) occupancy based, which tends to allocate costs to those funds which have the largest number of staff assigned to them.

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.