Should You Buy Stock Funds or Fund Company Stock?

"I decided there was only one place to make money in the mutual fund business—as there is only one place for a temperate man to be in a saloon, behind the bar and not in front of it . . . so I invested in a management company."

Nobel Prize-winning economist Paul Samuelson uttered those words at a 1967 Senate hearing on financial legislation, but it doesn't take a genius to see the truth in it. We compared the returns of the shares of publicly traded mutual fund companies with the average returns of their mutual funds and found Samuelson's quip to be as incisive today as it was nearly 40 years ago. In most cases investors would have done better with the firm's stock than with its average stock fund.

The dichotomy was consistent across all time periods we examined. Over the trailing one-, three-, and five-year periods ending Dec. 31, 2005, the shares of more than 70% of the public fund companies in our database outperformed the typical equity fund in their respective lineups. During the 10-year period ending Dec. 31, 2005, the shares of each and every public fund company did better than their average stock funds.

Big Difference
The difference between fundholder and shareholder returns was often stark.  U.S. Global Investors' (GROW) shares rose 24% on an annualized basis over the 10-year period ending in December, or five times the gain of the small shop's average equity fund. Over the same time period  Eaton Vance  shares rose more than 33% on an annualized basis, which was quadruple the average return of the typical Eaton Vance stock fund. Meanwhile, the shares of  Alliance Capital Management (AC) increased by an annualized 25%, or more than three times the return of the average AllianceBernstein equity fund.

The average funds of only two families,  Janus  and  Waddell & Reed , consistently beat the returns of their parent company's stock. The funds at each shop edged the stocks over the one-, three-, and five-year periods. That says more about internal turmoil at the respective companies than the performance of their funds, though. Janus has been through a wrenching period of leadership change, restructuring, and regulatory penalties in the wake of the mutual fund trading scandal and early 2000s bear market, which bled assets from its growth funds. A dispute with a former broker, which the firm recently settled for $7.9 million, as well as concerns about stricter regulations for brokers and advisors, has weighed on Waddell & Reed.

Major Margins
Fund company share returns show that the market, like Noble laureate Samuelson, recognizes a good thing when it sees it. Money managers are usually very profitable, with operating margins that often hit 35%. The business model is what they call scalable--that is it doesn't cost a fund manager any more to manage $100 million than it does to manage $10 million. And whether or not investors in their funds make money, fund companies still collect their fees on those assets.

Does this mean you should abandon funds and buy a batch of fund company stocks? No. That would be too risky. A bear market or regulatory scandal could rock these stocks. Furthermore, some of these firms are not as bulletproof as their returns and margins would indicate. Most of U.S. Global Investors funds, for example, focus on narrow market segments like natural resources and precious metals. Given the recent commodity rally, it's not surprising the market has favored this firm's shares. The company's concentration, however, could prove to be its bane when and if gold and oil prices slip.

Demand More
Comparing fund returns with those of the parent company's stock does, however, illustrate the tension that exists between a publicly traded fund company's duty to its shareholders and to its fund owners. It also shows the importance of demanding a higher standard for corporate culture and stewardship from your fund families. It's no coincidence that the firms with some biggest gaps between shareholder and fund owner returns, such as U.S. Global Investors, Alliance, and Eaton Vance, are not known for their low fees. There is nothing wrong with fund companies making a profit, but it's easier to accept when you know the firms charge fair fees and encourage their managers to invest alongside fund owners, a la  T. Rowe Price (TROW). All too often, that is not the case.