So, the annual process of renewing funds’ contracts is underway, and the Gartenberg factors and other matters are being considered by the independent directors. Comparisons and benchmarking surrounding expenses, performance, and other components are being tackled. However, a stumbling block can appear when fund profitability is discussed. Some of this is because of the relatively vague guidance provided around profitability oversight—with most of this guidance relating more to process and procedures than quantifiable measurements—and some of this results from the absence of fund-by-fund advisory profitability benchmarking. The outcome for fund directors can be that they struggle with difficult questions of how to best assess the figures and methodologies they are given.
This doesn’t mean that profitability calculations or the resulting figures are without value, though, or that there is a specific targeted advisory margin for every fund that is relevant. It simply means the consideration of the profitability component of contract renewal may need to involve a more robust and thoughtful process. At the end of the day, the fund-by-fund advisory margins can reflect the complete story of all the moving parts of each fund, but there may not be a “right profit margin” that applies to all funds. Still, there is a process that should leave the director confident they understand each individual fund’s profitability and that it is not unreasonable.
Start with the Big Picture
The director is charged with reviewing advisory profits on pre-marketing, fund-by-fund profitability figures, but it may be helpful to start discussions by considering the big picture. The board should look at firm-wide operating margins before getting mired down in the individual fund detail. This essentially enables directors to become familiar with the revenue and expense components of the business before attempting to understand how each fund contributes and determining the appropriateness of the funds’ advisory margins. Approaching profitability in the following context may allow boards to have more productive and conclusive discussions:
- Firm-wide pre-tax operating margins
- Business channel operating margins
- Product line operating margins
- Resulting individual fund-by-fund advisory margins
Another reason the complete firm view is helpful is that there is publicly available information for benchmarking. Of approximately 17 sample companies primarily engaged in the business of asset management, the 2018 pre-tax operating margin ranged from 15% to 44%, with a median of 32%*. This median has remained relatively constant the last 10 years. The median of these sample firms may be significantly different from the directors’ firm, but the exercise of benchmarking—and discussing the differences and similarities among sample firms—aids in understanding drivers and provides comfort around why a firm’s margins may be out of this range.
Reviewing operating margins by business line (e.g., distribution, marketing, administrative, advisory, transfer agency) summed to the firm total often can provide necessary information for directors, beyond just the advisory services. It’s important to remember that the support the firm provides fund investors does not stop at the advisory function, and the mutual fund investment advisory profits are only one piece of the story. This broader scope may help in assessing the reasonableness of advisory fees, as other business channels are typically either very low or unprofitable. Without this view, the advisory margins can appear unreasonably high.
Also imperative to the investor—and not always associated with the advisory expense allocation—are overhead expenses related to functions such as legal, regulatory and compliance. Without necessary investments in these areas (such as in key staff), the funds are subject to unacceptable risk. Investment in technology is an example of an expense that benefits the investor in the form of increased service levels, cybersecurity, and firm efficiency but which is not typically allocated to the advisory business channel. Being blind to the impact of distribution and administration, transfer agency, and overhead can lead to faulty assessments and decision making regarding the advisory profitability.
Because of these examples and others, it may be myopic and result in negative impacts on investors for boards to consider adjusting fund fees simply in response to advisory profitability or to target specific numeric advisory profitability goals.
A simple example of this is in a smaller firm with specialty products that may have higher fees and seemingly high advisory margins. Those figures alone don’t paint the whole picture. If there are large outflows, revenue may drop. A significant expense associated with the advisory margin is investment compensation, and a large portion of this is typically variable. In a large firm, declining assets may not change total firm advisory margins because of a large suite of products and scale. However, in the smaller specialty firm with higher advisory margins, where the scale isn’t as great, the fixed overhead fees have a greater impact and result in lower per-tax operating margins. This example can be adapted to every scenario for every firm, but the conclusion remains the same: It is important for directors to understand all drivers of the business, not only the investment slice.
Another view that offers insight is profitability by product channels summed to firm total. While the directors are responsible for the ’40 Act funds, they will have a greater understanding of where resources are being allocated (and the resulting margins) if they understand the impact of institutional or private high-net-worth accounts, for example, and the expenses allocated to those products versus the funds.
Now the board has an understanding of the firm profitability, the drivers of that profitability, and the big-picture view of how the advisory margin fits within this. As with firm-wide margins, advisory numbers for benchmarking can be obtained. Contrary to the firm’s pre-tax margin, however, these figures are estimates based on allocating expenses in a standardized methodology rather than internally calculated figures. Allocation methodologies are not dictated, and the result is that profitability logic, modeling, and calculations differ significantly among firms. Even if the resulting advisory margins were reported, they would not be comparable. The 2018 estimated median of the advisory margin of the sample firms mentioned above was 52%.
Difficulties in benchmarking continue to be compounded at the more granular individual fund level. Even if this information was available or estimated, because of differences in the size of funds, size of firms, distribution models, servicing models, fee structures, compensation models, and other factors, making profitability comparisons even between seemingly similar funds offered by different firms becomes relatively meaningless—and that’s even before the consideration of unknown internal expense allocation models.
This is where any value of attempted benchmarking ends, and the board’s knowledge and assessment of the business and the funds kicks in. The importance of two factors during this process can’t be emphasized enough: 1) effective board materials, and 2) interaction with the adviser.
To begin with, having a clear and detailed written explanation of the allocation methodology is needed to understand the resulting figures and determine that they have validity and weight. Next, all the resulting analysis discussed above is key; while directors must consider profitability on a fund-by-fund advisory level, profitability summarized by business channel, product, and firm also offers valuable insight. Lastly, trend reporting is a useful tool. The easiest way to see the impact of economic influences, performance, fee changes, staff changes, investments in business, etc., is year-over-year reporting. This analysis also can indicate existing economies of scale.
Perhaps most important is that all discussions, interpretations, and questions brought to light by the independent directors should be fully addressed by the adviser. The underlying details of not just the calculations, but the drivers of profitability, can become challenging, and the adviser is best suited to clarify all information provided.
Pièce de Résistance
This leads to the business at hand of fund-by-fund profitability.
When reviewing these results, directors shouldn’t be intimidated by how high or low advisory margins might be—even in the current litigious environment. Rather, directors should use the figures as a tool to understand the fund and the allocations. Often, greater attention is given to a fund with a high margin, but this doesn’t necessarily reflect an excessive fee or a failure of arm’s-length bargaining, to use legal ease.
The discussion of high advisory margins often continues beyond the advisory functions to factors such as the impact of distribution, marketing, and administration. For larger funds, the sharing of economies of scale with the investor also may become a consideration. Other Gartenberg factors that directors are reminded to consider when assessing margins are comparative expenses and performance. Essentially, boards are expected to look at the services for which the investor pays and the services the investor receives. As the industry and products have changed, volatility also has become a factor that can impact fund profitability. For example, index funds are more likely to see rapid asset changes that result in fluctuating profitability. Therefore, such a fund may have high profitability one year, and low profitability the next.
Low and negative advisory margins are just as common as high margins. Especially in this environment of low- and no-fee funds, revenues may not overcome the associated advisory expenses much less distribution or other expenses. In fact, this is anticipated for certain funds, since the fees are set for marketing purposes to attract assets to a brokerage platform and bring flows to other products. This is another reason it is becoming increasingly important to understand the individual fund but also the combined product profitability.
Of greater challenge to a board may be a fund with low or negative profitability because it hasn’t ever gained scale or has shrunk due to performance or lack of demand. This may be an indication that a longer-term plan for a merger or liquidation is needed.
There is no magic advisory profitability number to target, and each adviser is different. Directors should make sure they understand the financials, the business, the triggers, the allocation methodologies, and the resulting models. They should get comfortable with the process and consider the trends with each fund; assess the results in combination with the other Gartenberg factors; and have discussions with the adviser. If these are achieved and profitability is determined to be reasonable, there most likely will not only be a level of comfort among the fund directors, but also a greater understanding of the outside economic and internal influences on the funds.
Sara Yerkey is a partner at Management Practice Inc. She joined MPI in 2007 and focuses on the areas of mutual fund governance, contract renewal, and profitability analysis.
*Information sourced from the 2019 Management Practice Inc. Asset Management Industry Profitability Survey