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.

Voices
voicesGood for Lana Del Rey for helping kill that myth, writes Grace Dent
Sport
The Pipes and Drums of The Scottish Regiments perform during the Opening Ceremony for the Glasgow 2014 Commonwealth Games at Celtic Park on July 23, 2014 in Glasgow, Scotland.
Commonwealth GamesThe actor encouraged the one billion viewers of the event to donate to the children's charity
Sport
Karen Dunbar performs
Entertainers showcase local wit, talent and irrepressible spirit
Arts and Entertainment
The Tour de France peloton rides over a bridge on the Grinton Moor, Yorkshire, earlier this month
film
PROMOTED VIDEO
Have you tried new the Independent Digital Edition apps?
Life and Style
ebookA wonderful selection of salads, starters and mains featuring venison, grouse and other game
Life and Style
fashion Designs are part of feminist art project by a British student
News
Very tasty: Vladimir Putin dining alone, perhaps sensibly
news
Life and Style
Listen here: Apple EarPods offer an alternative
techAre custom, 3D printed earbuds the solution?
News
The University of California study monitored the reaction of 36 dogs
sciencePets' range of emotions revealed
Arts and Entertainment
The nomination of 'The Wake' by Paul Kingsnorth has caused a stir
books
News
Joining forces: young British men feature in an Isis video in which they urge Islamists in the West to join them in Iraq and Syria
newsWill the young Britons fighting in Syria be allowed to return home and resume their lives?
News
Snoop Dogg pictured at The Hollywood Reporter Nominees' Night in February, 2013
people... says Snoop Dogg
News
i100
Life and Style
food + drinkZebra meat is exotic and lean - but does it taste good?
News
Bey can do it: Beyoncé re-enacts Rosie the Riveter's pose
newsRosie the Riveter started out as an American wartime poster girl and has become a feminist pin-up. With Beyoncé channeling her look, Gillian Orr tells her story
Life and Style
Donna and Paul Wheatley at their wedding
healthShould emergency hospital weddings be made easier for the terminally ill?
Arts and Entertainment
Residents of Derby Road in Southampton oppose filming of Channel 4 documentary Immigration Street in their community
tv
Independent
Travel Shop
the manor
Up to 70% off luxury travel
on city breaks Find out more
santorini
Up to 70% off luxury travel
on chic beach resorts Find out more
sardina foodie
Up to 70% off luxury travel
on country retreats Find out more
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

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

ES Rentals

    iJobs Job Widget
    iJobs General

    BI Manager - £50,000

    £49000 - £55000 per annum + competitive: Progressive Recruitment: My client is...

    BI Project Manager - £48,000 - £54,000 - Midlands

    £48000 - £54000 per annum + Benefits package: Progressive Recruitment: My clie...

    VB.Net Developer

    £35000 - £45000 per annum + competitive: Progressive Recruitment: If you're pa...

    SAP Business Consultant (SD, MM and FICO), £55,000, Wakefield

    £45000 - £55000 per annum + competitive: Progressive Recruitment: SAP Business...

    Day In a Page

    Screwing your way to the top? Good for Lana Del Rey for helping kill that myth

    Screwing your way to the top?

    Good for Lana Del Rey for helping kill that myth, says Grace Dent
    Will the young Britons fighting in Syria be allowed to return home and resume their lives?

    Will Britons fighting in Syria be able to resume their lives?

    Tony Blair's Terrorism Act 2006 has made it an offence to take part in military action abroad with a "political, ideological, religious or racial motive"
    Beyoncé poses as Rosie the Riveter, the wartime poster girl who became a feminist pin-up

    Beyoncé poses as Rosie the Riveter

    The wartime poster girl became the ultimate American symbol of female empowerment
    The quest to find the perfect pair of earphones: Are custom, 3D printed earbuds the solution?

    The quest to find the perfect pair of earphones

    Earphones don't fit properly, offer mediocre audio quality and can even be painful. So the quest to design the perfect pair is music to Seth Stevenson's ears
    Climate change threatens to make the antarctic fur seal extinct

    Take a good look while you can

    How climate change could wipe out this seal
    Should emergency hospital weddings be made easier for the terminally ill?

    Farewell, my lovely

    Should emergency hospital weddings be made easier?
    Man Booker Prize 2014 longlist: Crowdfunded novel nominated for first time

    Crowdfunded novel nominated for Booker Prize

    Paul Kingsnorth's 'The Wake' is in contention for the prestigious award
    Vladimir Putin employs a full-time food taster to ensure his meals aren't poisoned

    Vladimir Putin employs a full-time food taster

    John Walsh salutes those brave souls who have, throughout history, put their knives on the line
    Tour de France effect brings Hollywood blockbusters to Yorkshire

    Tour de France effect brings Hollywood blockbusters to Yorkshire

    A $25m thriller starring Sam Worthington to be made in God's Own Country
    Will The Minerva Project - the first 'elite' American university to be launched in a century - change the face of higher learning?

    Will The Minerva Project change the face of higher learning?

    The university has no lecture halls, no debating societies, no sports teams and no fraternities. Instead, the 33 students who have made the cut at Minerva, will travel the world and change the face of higher learning
    The 10 best pedicure products

    Feet treat: 10 best pedicure products

    Bags packed and all prepped for holidays, but feet in a state? Get them flip-flop-ready with our pick of the items for a DIY treatment
    Noel Fielding's 'Luxury Comedy': A land of the outright bizarre

    Noel Fielding's 'Luxury Comedy'

    A land of the outright bizarre
    What are the worst 'Word Crimes'?

    What are the worst 'Word Crimes'?

    ‘Weird Al’ Yankovic's latest video is an ode to good grammar. But what do The Independent’s experts think he’s missed out?
    Can Secret Cinema sell 80,000 'Back to the Future' tickets?

    The worst kept secret in cinema

    A cult movie event aims to immerse audiences of 80,000 in ‘Back to the Future’. But has it lost its magic?
    Facebook: The new hatched, matched and dispatched

    The new hatched, matched and dispatched

    Family events used to be marked in the personal columns. But now Facebook has usurped the ‘Births, Deaths and Marriages’ announcements