Buy the Fund Company, Not the Funds?

Two for Two
It's said that the stocks of mutual fund companies make better investments than the funds those companies manage. Certainly, the stocks have thrived. The few publicly traded mutual fund companies performed fabulously in the 1980s (Franklin and Dreyfus were among the very highest gainers of any U.S. stock for the decade), beat the market again in the 1990s, and have gained nicely in recent years, too.

For example, although  T. Rowe Price (TROW) missed the indexing boom, including the exchange-traded fund market, its shares have gained more than 400% cumulatively over the trailing 10 years. Just a shade behind, at 370% for the trailing 10 years through Aug. 31, 2013, was  Franklin Resources (BEN), which not only bypassed indexing and ETFs but also the surging 401(k) marketplace. Both companies succeeded at their core task of investing--more on that shortly--but the point remains: The mutual fund industry is a generous master. Over the past five years, 4 times as many  Eaton Vance  funds have finished in the bottom quartile of its category than in the top quartile. The company's punishment? Its shares are only up 9.9% per year over the period.

In my investment lifetime, it has never been a bad time to own the stock of a mutual fund company. (I am not permitted to do so. You, on the other hand ... )

So, the first part of the saying is correct. The part about not buying the funds? Not so much. Below are the five-year numbers of the mutual funds (oldest share class) of the four largest publicly traded fund companies, listed in order of their companies' stock market capitalization. (After the top four, I've added Eaton Vance, which is quite a bit smaller than the other four, but it's a relatively pure play on the industry.) Each family's average category percentile ranking for total return over the trailing five years is shown, along with the number of funds that placed in the top and bottom quartiles of their categories over that period.

  - source: Morningstar Analysts

Good results, albeit from a small sample size. BlackRock's funds have been no better than average--but BlackRock, while the biggest overall asset manager of the listed companies, is neither the oldest nor the most prominent of the list's mutual fund managers. Those honors belong to Franklin and T. Rowe Price, which have respectively been very good and excellent.

T. Rowe Price in particular deserves mention. Placing 47 funds in the top quartile for the trailing five years and only five funds in the bottom quartile is a highly impressive feat. (Industry leader Vanguard, for example, which has dominated the sales charts over that time period, has 38 funds in the top quartile and seven in the bottom.) While T. Rowe rarely performs that well--which fund company does?--the showing is nevertheless typical of the firm, which chugs along decade after decade with quietly strong, scandal-free results.

Then comes  Invesco (IVZ) near the averages. Finally, as previously mentioned, Eaton Vance has very much struggled.

Jack Bogle writes that a private partnership is a better structure for a mutual fund company than is public ownership. Private partnerships tend to have the patience that is required to lead in the mutual fund business. Private partnerships will trade off maximizing current profits in exchange for improved long-term results. Capital Research (American Funds), GMO, DFA, and Dodge & Cox are prominent examples. Those organizations have strategic mind-sets that govern the launch schedule of their funds and that shape the character of their shareholder bases. They also tend to have experienced, long-tenured employees. Bogle is surely correct that such cultures are easier to create within a private company, as opposed to one that possesses outside shareholders who demand results now.

However, the admittedly thin evidence suggests that if a fund company is to have outside interests demanding profits, it is better that these interests be public shareholders than the CEOs of financial conglomerates. As with fund investors, public shareholders can, to an extent, be cultivated, so that a company with a long-term mind-set attracts (mostly) stock owners who have similar views. T. Rowe Price's and Franklin's stock owners have a pretty good sense of what those companies are about. (The same holds true for Morningstar's stock owners-- Morningstar (MORN) not being a mutual fund company, but the same argument applies.)

In contrast, it's difficult for financial CEOs to avoid squeezing their mutual fund subsidiaries. Just as former Mayor Daley forestalled Chicago Transit Authority repairs and the difficult aspects of city worker contracts, year after year, so that he could showcase seemingly attractive finances and harmonious labor relations, so, too, are CEOs tempted to instruct fund-company chiefs to help out the corporation, just this one year. Cut costs. Increase promotion on the company's best-selling fund. Launch a trendy fund. There are many things that can be done to help today's numbers and hurt tomorrow's numbers.

This discussion may soon become directly relevant for advisors and investors who use DFA funds, as it is rumored that DFA's principals are interested in cashing out on their highly successful investment. Were I a DFA advisor, I would prefer that the company be sold via a public offering rather than be gobbled up by a larger financial-services fish. The former does not guarantee success nor the latter disaster (MFS, for one, has thrived in recent years as a subsidiary of an insurance company), but that is where the odds seem to lie.

Better yet, buy some of DFA's equity if it goes public.

They Care, They Really Do Care
Morningstar's Chicago headquarters recently had a high-powered visitor:  Goldman Sachs (GS) CEO Lloyd Blankfein, telling the story of Goldman's asset management unit. With its traditional investment-banking business becoming less important to its fortunes and its trading activities threatened from various directions, Goldman clearly is placing a high priority on asset management.

That will be a tough task. While Goldman continues to enjoy the advantage of being able to hire the best and brightest, it suffers the major drawback of being a Wall Street brokerage firm. No Wall Street broker has yet succeeded at mutual fund management, the two cultures seemingly being too different to survive in the same company.

Goldman has not yet proved the exception to the rule. It's been at the fund business for a while now, and its numbers are unexceptional. On the five-year test done for the publicly traded fund companies, Goldman registers an average category ranking of 51, seven funds in the top quartile, and 10 funds in the bottom quartile. To be sure, that's good for a Wall Street broker--but it's not good overall. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.