Federated Investors 3rd-Quarter Earnings: Rising Markets Mask Customer Redemptions

Fund manager Federated Investors (FHI -1.17%) reported a 2.8% increase in net income in the third quarter compared to the year-ago period. Its earnings were helped by rising stock and bond prices, which helped stem a decline in assets due to customer redemptions.

Federated Investors' third quarter: The raw numbers

Data source: Federated Investors.

Asset managers have only a few levers that really matter. Ultimately, the business boils down to how much money a company manages, the average fee it can charge to clients for its services, and its ability to manage expenses so as to maximize the portion of fees that make their way into pre-tax income.

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What happened this quarter

• Federated is facing challenges growing and retaining client wealth under management. Total average managed assets declined 1.3% year over year, driven by a 3.4% decline in average money market assets under management. On a sequential basis, total average managed assets were roughly flat, growing just 0.1% from the second quarter.
• Its legacy money market products continue to bleed assets. Average assets under management (AUM) in money market strategies declined 0.2% to $241.8 billion, down from $242.3 billion in the second quarter. Equity and fixed-income strategies fared better, as average AUM grew 1.1% (equity) and 0.7% (fixed income) quarter over quarter.
• Rising markets, not increased client investments, are driving AUM increases in its highly profitable equity and fixed-income products. Federated's investors redeemed more from its equity and fixed-income offerings than they added (roughly $1 billion on a combined basis) during the quarter.
• Total revenue, most of which is derived from management fees charged to clients, fell 5.5% year over year, but rose about 2% sequentially. Fortunately, asset management companies often have some variable costs to offset revenue fluctuations. Operating income grew 5.3% quarter over quarter, and 0.1% year over year, due to expenses rising slower, or falling faster, than revenue.

What management had to say

The press release quoted management's positive statement about the performance of the company's fixed-income funds, many of which are beating their peers in the most recent one-year period.

"At the end of the third quarter, 85 percent of Federated's rated domestic bond-fund assets had outperformed their category averages on a one-year basis," said CEO J. Christopher Donahue. "Federated continued to see positive flows in our flagship multisector bond fund, the $7.5 billion Federated Total Return Bond Fund, a strategy that incorporates our firm's highest-conviction ideas about different fixed-income asset classes."

Bond funds have enjoyed a good start to the year, despite Fed rate increases. The Bloomberg Barclays U.S. Aggregate Bond Total Return index is up approximately 3.1% year to date, on track to put up the best return since 2014. 

Looking ahead

A slide in the company's earnings reveals the importance of non-money market AUM to Federated Investors' top and bottom lines. It points out that money market strategies made up two-thirds of Federated Investors' AUM but generated only 30% of its fee income after distribution expenses this quarter. Fixed-income and stock strategies made up only a third of AUM, but generated 70% of fee income, after accounting for distribution expenses.

All this to say that, on average, a dollar of client capital invested in its equity and fixed-income strategies is worth more than twice as much to Federated Investors as a dollar invested in its legacy money market products. Growing these two strategies remains a priority for the company.

But not all growth is created equal. Shareholders will want to see that Federated Investors can grow AUM without the help of rising stock and bond prices. While all AUM growth is good, the very best asset-management companies grow AUM by convincing investors to invest more in their products than they withdraw over time. 

If Federated Investors can stem customer outflows, and attract inflows, in its highly profitable equity and fixed-income strategies, increasing stock and bond prices will only serve to magnify its AUM and profit growth over the long haul.