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.

Have you tried new the Independent Digital Edition apps?
Life and Style
ebookNow available in paperback
ebookPart of The Independent’s new eBook series The Great Composers
Arts and Entertainment
Buttoned up: Ryan Reynolds with Helen Mirren in ‘Woman in Gold’
filmFor every box-office smash in his Hollywood career, there's always been a misconceived let-down. Now he says it's time for a reboot
Actress Julianne Moore wins the Best Actress in a Leading Role Award for 'Still Alice' during the 87th Annual Academy Awards in Hollywood, California
Ross Barkley
footballPaul Scholes says it's time for the Everton playmaker to step up and seize the England No 10 shirt
'We will fix it': mice in the 1970s children’s programme Bagpuss
Life and Style
2 Karl Lagerfeld and Choupette
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs General

    Recruitment Genius: Customer Service Executive

    £18000 - £22000 per annum: Recruitment Genius: This is an exciting opportunity...

    Recruitment Genius: Retail Buyer / Ecommerce Buyer

    £30000 - £35000 per annum: Recruitment Genius: Working closely with the market...

    Recruitment Genius: Sales Executive - CAD Software Solutions Sales

    £20000 - £50000 per annum: Recruitment Genius: A reputable company, famed for ...

    Ashdown Group: Client Accountant Team Manager - Reading

    Negotiable: Ashdown Group: The Ashdown Group has been engaged by a highly resp...

    Day In a Page

    War with Isis: Iraq declares victory in the battle for Tikrit - but militants make make ominous advances in neighbouring Syria's capital

    War with Isis

    Iraq declares victory in the battle for Tikrit - but militants make make ominous advances in neighbouring Syria
    Scientists develop mechanical spring-loaded leg brace to improve walking

    A spring in your step?

    Scientists develop mechanical leg brace to help take a load off
    Peter Ackroyd on Alfred Hitchcock: How London shaped the director's art and obsessions

    Peter Ackroyd on Alfred Hitchcock

    Ackroyd has devoted his literary career to chronicling the capital and its characters. He tells John Walsh why he chose the master of suspense as his latest subject
    Ryan Reynolds interview: The actor is branching out with Nazi art-theft drama Woman in Gold

    Ryan Reynolds branches out in Woman in Gold

    For every box-office smash in Ryan Reynolds' Hollywood career, there's always been a misconceived let-down. It's time for a rethink and a reboot, the actor tells James Mottram
    Why Robin Williams safeguarded himself against a morbid trend in advertising

    Stars safeguard against morbid advertising

    As film-makers and advertisers make increasing posthumous use of celebrities' images, some stars are finding new ways of ensuring that they rest in peace
    The UK horticulture industry is facing a skills crisis - but Great Dixter aims to change all that

    UK horticulture industry facing skills crisis

    Great Dixter manor house in East Sussex is encouraging people to work in the industry by offering three scholarships a year to students, as well as generous placements
    Hack Circus aims to turn the rule-abiding approach of TED talks on its head

    Hack Circus: Technology, art and learning

    Hack Circus aims to turn the rule-abiding approach of TED talks on its head. Rhodri Marsden meets mistress of ceremonies Leila Johnston
    Sevenoaks is split over much-delayed decision on controversial grammar school annexe

    Sevenoaks split over grammar school annexe

    If Weald of Kent Grammar School is given the go-ahead for an annexe in leafy Sevenoaks, it will be the first selective state school to open in 50 years
    10 best compact cameras

    A look through the lens: 10 best compact cameras

    If your smartphone won’t quite cut it, it’s time to invest in a new portable gadget
    Paul Scholes column: Ross Barkley played well against Italy but he must build on that. His time to step up and seize that England No 10 shirt is now

    Paul Scholes column

    Ross Barkley played well against Italy but he must build on that. His time to step up and seize that England No 10 shirt is now
    Why Michael Carrick is still proving an enigma for England

    Why Carrick is still proving an enigma for England

    Manchester United's talented midfielder has played international football for almost 14 years yet, frustratingly, has won only 32 caps, says Sam Wallace
    Tracey Neville: The netball coach who is just as busy as her brothers, Gary and Phil

    Tracey Neville is just as busy as her brothers, Gary and Phil

    The former player on how she is finding time to coach both Manchester Thunder in the Superleague and England in this year's World Cup
    General Election 2015: The masterminds behind the scenes

    The masterminds behind the election

    How do you get your party leader to embrace a message and then stick to it? By employing these people
    Machine Gun America: The amusement park where teenagers go to shoot a huge range of automatic weapons

    Machine Gun America

    The amusement park where teenagers go to shoot a huge range of automatic weapons
    The ethics of pet food: Why are we are so selective in how we show animals our love?

    The ethics of pet food

    Why are we are so selective in how we show animals our love?