The Wrong Shareholders I was reminded by Barron's, which invited me to discuss the subject, that the fund industry continues to consolidate. This year, Franklin Resources BEN purchased Legg Mason and Morgan Stanley MS announced that it would buy Eaton Vance. Then hedge fund manager Nelson Peltz acquired 9.9% positions in both Invesco IVZ and Janus Henderson JHG, while suggesting that the two businesses should combine.
If so, that transaction would be fitting, because those companies long ago shed their original breeding. Founded in Atlanta, Invesco was later purchased by a British firm, which then acquired the mutual fund companies of AIM, Van Kampen, Guggenheim Investments, and OppenheimerFunds. For its part, Janus Henderson was formed in 2017, when Denver's Janus Capital merged with Britain's Henderson Group. If these firms were dogs, they would be oodles.
Unhappily for fund shareholders, such deals are made solely, completely, and utterly to benefit those who own the fund companies. As Jack Bogle wrote, fiduciaries can serve but one master. Ultimately, fund-company executives answer to a single party, and that party consists of shareholders who invested in the business itself, as opposed to shareholders who bought that business' funds.
(Although this principle is often credited to the doctrine of shareholder value, it predates that mandate. Three years before Milton Friedman argued that CEOs should focus solely on improving profits, Paul Samuelson testified to Congress, "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, I invested in a mutual fund management company."
Never again claim that economists are poor investors. Franklin Resources went public in 1984 at a split-adjusted price of 2 cents. The stock is now worth $22.70, making for a modest gain of 111,350%. T. Rowe Price TROW hasn't fared badly, either, improving from 86 cents per share in 1989 to a current $145, which exceeds the performance of any U.S. mutual fund over that 31-year period. Owning the tavern has indeed paid handsomely.)
Watchlists Typically, investment consultants put funds from companies that are purchased onto their watchlists (a process also known as double secret probation). Their major concern is with the investment process. At best, the portfolio managers will be distracted, by both the turmoil and by questions from customers, consultants, and other interested parties (including, yes, Morningstar researchers). At worst, they will leave their jobs, either because they sought greener pastures or because the organization deemed their positions redundant.
That is a legitimate worry. After such deals are announced, portfolio managers typically are deflected from their daily responsibilities, frequently choose to leave the company, and may be kicked upstairs by the new entity. (They rarely are fired, because fund companies typically promise their customers that business will remain “as usual.”) Those disruptions can harm fund performance.
(Unhappily, distinguishing between results that owe to organizational disruption and those that arise from investment noise is very difficult. Consequently, many watchlist funds are terminated for dips in relative returns that are regarded as meaningful but that are nothing more than sound and fury, signifying nothing. When outsiders lack the information to make informed judgments, they tend to shoot first and ask questions later.)
Fund Mergers Another problem is that the portfolio managers remain but the funds disappear. Per Morningstar's Syl Flood, more than 1,000 mutual funds have been merged out of existence during the past three years alone. Syl's list includes multiple share classes, as well as mergers that occurred for reasons other than organizational changes, but the point remains: After fund companies merge, fund shareholders often find themselves owning something that is other than what they purchased.
That is not necessarily a bad thing. Generally, the surviving fund has a better track record than the extinguished fund, as fund companies sell past performance. Better past results don’t mean that the surviving fund is superior to the one it absorbed, but neither is there evidence that it is clearly worse. In addition, fund mergers are not taxable events, as the investor’s cost basis is shifted from the previous fund into the new acquisition.
On the other hand, who volunteers to buy randomly selected mutual funds? Because that is what occurs when one fund is merged into another. Shareholders in funds that are liquidated forgo an investment that they directly chose, with the proceeds placed into a security they knew nothing about. Strangely, most people accept that exchange. Such is the power of inertia.
The Clearest Signal My biggest misgiving about fund-company transactions, though, lies neither with the mindset of portfolio managers nor the possibility that a fund might be abolished, but instead what the deal signals about the organizations themselves. The best fund companies tend to avoid such actions. The five largest managers of U.S. mutual funds and exchange-traded funds are 1) Vanguard, 2) BlackRock BLK, 3) Fidelity, 4) American Funds, and 5) State Street. None have been major buyers of other fund companies, save for BlackRock's 2009 purchase of Barclays' ETF business.
Neither are the worst fund companies involved, because they lack the assets to be important. The big transactions occur when one also-ran buys another. Both firms are healthy enough to persist, because the fund business is highly profitable, but they cannot realistically challenge the industry leaders. So, they do a deal. If nothing else, the new entity will improve its margins through cost savings. Less likely, but always possible, the combination will spark additional growth.
Rarely, though, will fund shareholders profit from the transaction. They are, after all, quite beside the point.
John Rekenthaler (firstname.lastname@example.org) 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.