The Jonathan Davis Column

Fund management companies have had a phenomenal run - but they would be wrong to assume it will last forever

IF YOU look back 12 years to Big Bang, the deregulation of the Stock Exchange, I suppose it was obvious that fund management would be one of the growth industries of the new era. There is no doubt that the end of negotiated commissions and the cosy duopoly of brokers and jobbers, coupled with the transforming power of information technology, has seen a real and enduring shift in power from the "sell" side of the business to those on the "buy" side. It no longer makes any sense to regard fund management as the poor relation of the securities industry, as was certainly the case when I first started working in the City.

Even so the pace of change has been quite remarkable. Anyone for example who had dared to predict 10 years ago that Mercury Asset Management, the once sleepy fund management arm of Warburgs, would eventually be sold for more than pounds 3.1bn to the mighty Merrill Lynch would have been asked to go away and lie down until the feeling went away. Just as remarkable in its way is to travel on the Underground and see so many posters competing for ordinary investors' money - with photographs of the fund managers staring out at you. That too would not have been conceivable in the old City, which would have regarded such ostentation as vulgar.

Of course, it is fair to say that the bull market has played a big part in the transformation of fund management from the City's ugly duckling to today's much sought after business. In rising markets, there is virtually no business to beat fund management (which is one reason why all the big investment banks are falling over themselves to try and snap up the best specialist firms for fancy prices). The reason fund management is so profitable stems from its fee structure, which in most cases takes the form of an annual management fee linked to the value of funds under management.

Thus, to take an example from the retail business, a typical unit trust will charge an annual management fee of between 1 per cent and 1.5 per cent of the money you have invested with it. If a firm has pounds 500 million of funds to look after, that adds up to an annual fee of pounds 5m-pounds 7.5m. If the market rises by 20 per cent over the year, provided that the fund manager does no more than keep pace with the index, it means that the firm's income rises automatically by the same amount.

What's more, with such market-derived gains, there is next to no increase in costs, at least in theory. It costs no more to look after a portfolio which has risen by 20 per cent in value than it did before, so the extra revenue should flow almost entirely to the bottom line. When stock markets are rising, this is a very nice business indeed: what other business offers 20 per cent annual increases for no extra effort or cost? As I have noted before, it is no accident that shares in fund management companies have consistently outperformed the market as a whole over the last few years. If you were lucky enough to catch Perpetual when it was in the bargain basement category, you could have made a real fortune.

An obvious question however is what happens when markets run out of steam, as they will do one day soon (Wilhelm Buiter, one of the economic pundits on the Bank of England's monetary committee, put it well this week, I thought, when he said that the current stock market bubble will burst eventually, but only "the Lord Almighty knows precisely when" - and He of course ain't telling).

Nobody should know better than fund managers that markets go up and down, so you would imagine that as an industry the fund management companies are already starting to hunker down in preparation for the leaner years ahead. Well, not so, according to the management consultants Pricewaterhouse Coopers, in their latest annual survey of the investment management industry, published a few days ago. This shows that, as you would expect, fund management companies had another excellent year last year. The market turned in its best performance of the decade. Revenues were up accordingly with fee levels broadly unchanged. Yet overall profitability of the industry was no better than it was three years before, and one in three firms actually experienced a decline in profit margins.

What is happening is that costs are rising faster than they should be. According to Pricewaterhouse Coopers, annual cost inflation in the industry is running at 8 per cent per annum, double the rate of inflation. The biggest cost increases over the last five years have been in marketing (up 15 per cent per annum), research and the cost of hiring fund managers themselves.

The message is clear, say the consultants: "Costs could be more closely managed. Analysis of costs reveals why the industry has failed to increase profits significantly." The danger for the fund management business, therefore, is that it too may suffer the way that many other growth businesses suffer, by assuming that the good times will roll forever. Letting costs get out of control in a business which is already highly geared to the level of the stock market is a recipe for potential trouble.

If the market were to fall by 10 per cent, reckon the consultants, it would send around a fifth of the firms in the business into loss. Average profitability would fall by nearly 50 per cent. True, this needs to be kept in perspective. The most profitable firms make profit margins of over 50 per cent, and the average profit margin is currently a mouth-watering 33 per cent. So there is still leeway for the best positioned firms to do well.

As an ordinary investor, you may care to dwell on the fact that the retail segment of the market, the one you are in, is the most profitable and fastest growing segment of the lot. The retail sector (unit trusts, life insurance funds and pension funds) accounts for 7 per cent of total funds under management, but 22 per cent of the profits. The investment management industry has targeted retail funds for a big push in the next few years. The smart investor, rather than being taken for an unnecessary ride, should seek to use this competition to his advantage by shopping around. That way you may be able to control your fund management costs rather better than the industry is controlling its own. I see no reason why retail investors should subsidise the industry's lax management habits.

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