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The Best Way to Win with Actively Managed Funds

"I decided that there was only one place to make money in the mutual fund industry, as there is only one place for a temperate man in a saloon: behind the bar and not in front of it."
- Paul Samuelson, Nobel Laureate, Economics
Hundreds of books, academic articles, newspaper columns, and even blog posts have chronicled the futility of winning the active management derby. As my MoneyWatch colleague Larry Swedroe pointed out just last week, the vast majority of actively managed funds end up lagging their index benchmarks, which is why he, and most of us here at MoneyWatch, encourage investors to use index funds for the bulk -- if not the entirety -- of their portfolio.

But for those investors who just can't bring themselves to relinquish the dream of outperformance, today I'm going to share with you what I think is perhaps the best way to earn rewards from actively managed funds: own the management company.

The five largest publicly held mutual fund managers (in terms of assets under management) are BlackRock, Franklin Resources, Federated Investors, T. Rowe Price, and Bank of New York Mellon. Combined, these firms oversee nearly $2 trillion in mutual fund assets.

Why do I suggest that you would be better served to own the stock of firms like these instead of the funds they run? Well, over the past decade, the stock of these firms, on average, has provided an annual return of 7.3 percent, a rate that would have grown $1 to $2.03. By contrast, the average equity fund run by this group (including domestic, international, and sector funds) has produced a 5.1% annual return in that same period, which would have grown $1 to $1.65.

It's not hard to figure out the reason for the disparity between the two returns, recognition of which led to Paul Samuelson's famous quip above. Outperforming the stock market is terribly difficult, requiring heavy doses of skill, patience, and luck. The odds of success are worse than 50/50, which is why so many professionals who don't have a vested interest in your choice recommend that you eschew the hope for market-beating rewards in exchange for accepting the guarantee of market-matching returns via index funds.

But that perspective changes quite a bit if you put on your management company owner's hat. Despite indexing's surge in popularity, there's a lot of money -- roughly 75 percent of all equity fund assets -- invested in actively managed funds. Even better, the bulk of those assets tend to be "sticky," as most investors, having made their initial selection, tend toward inertia. Unless your fund completely blows up, the likelihood is that your investors will stick with you.

Better still, the mutual fund industry offers tremendous economies of scale. If you're able to double your assets under management, your fees double too. But your costs don't. A $2 billion fund, for instance, doesn't incur anything close to twice the amount of overhead costs that it did when assets were $1 billion. So, happily, most of that increased revenue falls directly to your bottom line.

Recognition of the appealing economics of asset management were on display earlier this year in a press release touting Ameriprise's acquisition of Columbia Management. The acquisition "enhances our scale, broadens our distribution and strengthens and diversifies our lineup of strong performing retail and institutional funds," said Ameriprise chairman and CEO Jim Cracchiolo. "Importantly," he pointed out, "the transaction allows us to capture essential expense synergies [read, economies of scale] that will be instrumental in driving improved asset management returns and margins over time." [Emphasis added.]

Now, if I were an investor in a Columbia or Ameriprise fund, I might read that and wonder why there's no mention of my interests. On the other hand, if I were an investor in Ameriprise, I'd have reason to hope that this transaction would increase the return on my investment, given the relationship between assets under management and revenue.

The reality is that the latter is what it's all about in the asset management business. Which is why, as Paul Samuelson noted, you stand a much better chance of reaping the rewards of actively managed funds if you're selling them than if you're buying them.

You should follow me on Twitter here.
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