Is the Price of Money Managers Too Low?
Abstract (Via Columbia)
Although established money managers operate in an environment which seems competitive, they also seem to be very profitable. The present value of the expected future profits from managing a collection of funds is equal to the value of the assets under management multiplied by the profit margin, assuming that the managed funds will remain in business forever, and that there will be zero asset flow into and out of the funds, zero excess returns net of trading costs, a fixed management fee proportional to the assets under management and a fixed profit margin for the management company. A profit margin of 30% seems empirically reasonable, but money management companies seem to trade at 2-4% of assets under management. Attempts to reconcile the two figures are not compelling, which is disturbing considering the centrality of the present value formula to finance and economics. Another computation suggests that holders of actively managed funds typically lose about 12% (18%) of their assets if they hold the fund for 20 (30) years, as compared with a loss of less than 3% (5%) for low-cost index fund investors for similar holding periods.
Introduction (Via Columbia)
There are hundreds of mutual fund families, barriers to enter the money management business seem low and little capital is tied up in that business, all of which suggest that the industry is competitive and that its producers should therefore have low if not zero profits. How does the market set the price of these expected future profits, i.e., how does the market price the equity of established money management firms?
Assuming that the annual rate of interest is fixed at R, consider a firm that manages a short term bond mutual fund and charges a fee at the end of each year equal to a fraction c of the assets under management. Assuming that it initially manages $A, and that the clients neither add nor withdraw money from the fund, the stream of income that the management company will receive is: A(1 + R)c at the end of the first year, A(1 + R)2(1 − c)c at the end of the second year, A(1+R)3(1 − c)2c at the end of the third, etc. At the discount rate R, the present value of this stream is A — the value of the assets under management. The management company uses its revenues to pay for asset gathering, retention and servicing, and portfolio management. It also pays income taxes on its profits. The rest goes to the management company’s owners. Empirically reasonable estimates of the pre-tax and after-tax profit margins are 35% and 20%, respectively. Such profitability seems difficult to reconcile with the industry being highly competitive.
This back-of-the-envelope calculation indicates that money management firms should be priced at between 20% and 35% of the assets under management. But they are priced at 1- 4% of assets under management, a pricing range which applies to both private transactions, and to ten publicly traded money management firms.