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Muddled Mellon

Change has been afoot this year at Mellon Financial (NYSE: MEL  ) . The company brought in a new CEO, boosted its asset management capability with the acquisition of Walter Scott & Partners, and divested its insurance premium financing business. Strong year-to-date returns for Mellon shares and improving results in its financial statements would seem to validate the firm's strategic direction.

Mellon's performance, however, remains less than it could be. Radical change in the bank's structure is needed to make Mellon an attractive investment relative to the stocks of certain competitors. Robert Kelly, the new CEO, should reevaluate the strategy that brought together asset management and securities processing at Mellon.

Mellon earned $0.53 per share in the third quarter, one cent above analysts' consensus estimate and 15% better than the results from a year ago. The improvement was driven largely by the growth in assets under management, which increased 20% to $918 billion. Mellon Asset Management, which handles retail and institutional funds, and Mellon Private Wealth Management, the private banking unit, generated approximately 70% of total income before taxes.

In addition to a strong growth rate, the business of managing clients' money is attractive for the high investment returns it generates. Mellon Asset Management had a return on equity of 50% in the third quarter compared to the 31% return generated by the company's Asset Servicing unit. Investment managers tend to earn higher rates of return on invested capital than the average company in the sector.

Mellon is quick to point to substantial growth from the previous year in assets under custody or administration, a measure of activity at the Asset Servicing unit. But Mellon's ranking among securities processing firms remains stuck behind industry leaders like JP Morgan Chase (NYSE: JPM  ) , Bank of New York (NYSE: BK  ) , and State Street (NYSE: STT  ) . And scale is critically important in the capital-intensive and low-margin business of providing back-office functions such as record-keeping, custody, and administration.

Mellon's management has defended the bank's current structure by arguing that asset servicing and asset management are complementary functions. Asset servicing reduces the impact of bear markets on Mellon's earnings and likely shields the stock from the volatility that affects the high beta stocks of asset managers like T. Rowe Price (Nasdaq: TROW  ) and Affiliated Managers Group (NYSE: AMG  ) .

Nevertheless, the market continues to reject the wisdom of management's reasoning. In spite of the size and success achieved by Mellon's asset management unit, the firm's shares trade at a P/E multiple comparable to other custody banks rather than at the more robust multiples that other asset managers enjoy.

Mellon's management recognizes the value of developing its asset management business. Rumors had been circulating that Mellon wanted to buy the Boston-based advisor MFS Investment Management from its Canadian parent Sun Life (NYSE: SLF  ) . That transaction will not occur now that Sun Life has announced it intends to hold onto MFS. Perhaps Mellon's management will take the opportunity to focus its attention instead on a transaction that finally uncouples the asset servicing unit from the more substantial asset management business.

For related reading:

JPMorgan Chase is anIncome Investorrecommendation. Affiliated Managers Group is a former Stock Advisor pick.

Fool contributor Michael Leibert welcomes your feedback. He owns shares of Bank of New York. The Fool has an ironclad disclosure policy.

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