Morningstar: Fund Shareholders Fare Better than Investors

August 25, 2003 ( - Structural changes such as the appointment of more independent directors are urgently needed in mutual fund management companies to combat the "inherent tug of war" between the interests of management company shareholders and fund investors, according to Morningstar.

Reforming the current fund-management system may not rebalance the mismatch in power between investors and fund-company owners, but it would certainly give fund shareholders a better chance at equal treatment, contends Morningstar editor Kunal Kapoor in the current edition of the Morningstar Mutual Funds newsletter . “While the industry is unlikely to emulate the Vanguard (Group)  model – in which the owners of the funds own the fund company, too – fund boards must be more active in guarding fund shareholders’ interests,” Kapoor argued

Not only do fund managers need more independence in the boardroom , other reforms would also help, Kapoor said:

  • Fund managers need to more fully disclose their costs – particularly mangers’ compensation. “It’s important to know the way a manager is compensated because it can significantly affect how a fund is run,” Kapoor claimed. “If a manager’s pay goes up based on the assets in the fund, there’s less incentive to close ballooning funds.” Disclosures also need to include soft-dollar payments and estimates of trading impact, he said.
  • Larger fund managers should limit the number of fund boards on which a director can serve so they can better “set the agenda” about discussing the fund’s direction. “Currently, individuals can serve on scores of fund boards, so they aren’t as prepared as they ought to be,” Kapoor wrote.

According to Kapoor, the divergence between the interests of investors and fund manager shareholders is a simple matter of dollars: Investors benefit from low fees while company shareholders make more money when fees are high. Not only that, said Kapoor, but fund investors make out better when funds are closed before they reach gargantuan size, while management shareholders rake in more dollars when fund assets continue to grow.

To judge by the profitability of fund companies and the performance of their stocks, management firm shareholders appear to be winning, according to Kapoor.   The author argued that it’s no accident that fund managers at high-profile shops such as Ariel, Gabelli, Oakmark, and Tweedy, Browne love to invest in their own industry because they like firms with high cash flow and asset managers that are “cash-flow machines.”

They’ve also delivered super returns for shareholders.  Over the past decade, the average money management stock has returned a stunning 16.63% annually through mid-2003, outpacing the S&P 500 by more than 6.50% annually, the Morningstar editor contended.  Further, fund companies as an investment have “held up remarkably well” given how much damage the bear market has done to the average investor’s portfolio, he said. Equally important, those that have attracted assets haven’t felt a pressing need to cut expenses.

In the case of Gabelli Asset Management, the firm’s three largest offerings – Gabelli Asset, Gabelli Growth, and Gabelli Value – each with more than $1 billion in assets, charge an “egregious” 1.36%, 1.40%, and 1.40%, respectively, according to the report. Those fees fuel operating margins in the 40% range that have helped deliver annual gains of more than 16% to Gabelli Asset Management stockholders for the trailing three-year period through August 1, 2003. “To be sure,” Kapoor argued, ” both fund shareholders and stockholders can’t be happy about CEO Mario Gabelli’s 2002 salary, which exceeded $30 million.”

Kapoor said that the most significant disparities among large fund houses between the relative standing of fund shareholders and fund-company stockholders is at those funds with loads.   According to the Morningstar editor's data, Eaton Vance, Alliance, and Federated are cases in point. Shares of Eaton Vance and Federated have enjoyed "incredibly strong runs" with Eaton Vance's shareholders enjoying annual gains of approximately 25% for the trailing five-year period through August 1, 2003, while Federated stockholders have seen their shares skyrocket by 19.8% over the same period. The firms' shareholders enjoy net margins well above 20% and a return on equity of approximately 40% or higher. Noted Kapoor, "With profitability like that, it's easy to see why the stocks have soared."

Owners of Alliance Capital's units haven't been quite as lucky, but they're not hurting, Kapoor said. Despite that the firm's business is often mentioned in a less favorable light than its peers, its units have nevertheless jumped more than 15% over the same period. Here again, its stockholders have been rewarded with net margins of more than 20%.

But investors in the firms' funds haven't done nearly as well, according to Kapoor. For the trailing five-year period through August 1, the weighted average return of all Eaton Vance funds is just 0.08%. For Federated, that number is 3.08%, while it's 2.29% at Alliance. Partly, that's because these firms' funds aren't cheap: Despite a large number of fixed-income offerings, Eaton Vance's weighted average expense ratio is above 1.40%, while Federated charges approximately 1.17% on a weighted average basis. Alliance, meanwhile, has a weighted average expense ratio more than 1.60%.

On the other hand, Kapoor said, no-load offerings such as Strong Growth, RS Emerging Growth, Royce Low-Priced Stock, Marsico Focus, and many others are priced too high. "While it's true that some surcharge is to be expected to service the large number of small retail accounts that funds often have to contend with, the comparison with lower fees on institutional products is stark," the author argued.

So, with the current fund management system, the expense structure overall is designed for maximum profitability for the stockholders, not fund shareholders, Kapoor said. "More importantly, this setup creates incentives to leave funds open too long, maintain expenses at substantially higher levels for mutual funds than institutional accounts, push funds that are on short-term hot streaks, and introduce new funds after asset classes have run," he argued.

Those where the interests of fund investors and management company shareholders have been so far apart should look around at their competitors, he argued.

"To be sure, there are fund companies, public and private, load and no load, that realize the best way to serve their stakeholders is to serve fund shareholders," Kapoor said. "One group need not benefit at the expense of the other. "