All your life, the mutual fund industry has told you that investing in its funds is the best way to achieve financial success. While fund shareholders have seen their fortunes rise and fall, however, many of the companies that offer those funds have consistently found ways to make profits for their own businesses, both in good times and in bad.
Betting on the house
Any gambler knows that it pays to bet on the house. Just as investors in Wynn Resorts can count on the rules of table games to stack the odds in their favor against the casino operator's gambling customers, so do mutual fund companies prefer to avoid the uncertainty of investing in the financial markets. By taking a cut off the top, these companies have no direct exposure to the wild market movements that their fund-holding customers must deal with every day.
In particular, the model that most mutual fund companies use is a direct path to profits. Most funds charge a constant annual management fee that is completely unrelated to the performance of the fund. Whether the fund falls 40% in a year like 2008, or rises 50% in a bounce like last year's recovery, fund companies slowly but surely drain off your profits -- or take part of your capital, if the funds you own can't manage to make money for you.
The numbers don't lie
You can't fully appreciate the sheer magnitude of fund industry profits until you see them up close and personal. That's why you need to take a look at the following numbers, which come from some of the best-known public asset-management companies:
|
Stock |
2008 Net Income |
2009 Net Income |
Net Profit Margin |
|---|---|---|---|
|
Blackrock |
$784 million |
$875 million |
21% |
|
Franklin Resources |
$1.59 billion |
$897 million |
27% |
|
Brookfield Asset Management |
$649 million |
$454 million |
7% |
|
T. Rowe Price |
$491 million |
$434 million |
26% |
|
AllianceBernstein |
$245 million |
$167 million |
89% |
|
SEI Investments |
$139 million |
$174 million |
19% |
Source: Capital IQ, a division of Standard and Poor's.
That's a healthy chunk of cash on the bottom line for fund companies, especially during a period in which so many companies in other industries were losing huge amounts of money. Even within the financial industry, Citigroup
Even more revealingly, nearly all of these companies made more money in 2008, the year of the stock market's big loss, than they did last year. That's due largely to the way the market played out; most of the damage to ordinary investors came late in 2008, so the asset base on which fees were taken was still relatively high during most of 2008. Then, in 2009, markets took time to rebound, so fees were calculated on a lower asset base for most of the year.
How to win
From one perspective, if you can't beat the fund companies, you might want to join them. The companies above have made excellent long-term investments for company shareholders, with average returns near or above 20% annually. Those numbers even put many casino stocks to shame.
But if you're a mutual fund investor, you shouldn't take the figures above as a sign that you have to stop investing in mutual funds entirely. Using mutual funds can still make a lot of sense for investors, but you have to be smart about it. In particular:
- Watch the fees. The lower the fee, the less your fund manager is taking from your profits.
- Hold your fund accountable. If your fund can't outperform its benchmarks by at least the amount it charges as a fee, then your fund's managers aren't earning their keep. Go to a low-cost index fund instead.
- Pay for performance. Conversely, you may want to seek out funds that have a direct stake in the fund's returns. Some funds, for instance, earn more or less in management fees depending on whether they beat or fall short of their benchmarks. That puts a greater incentive on managers to do everything they can for their investors.
In a world in which middlemen seek to separate you from your hard-earned money, finding investments you can trust is more difficult than ever. Watching your fund company profit even when you're losing thousands in the markets is never pretty. By making sure you pay no more than you have to for a good mutual fund, you'll do your best to keep all your long-term profits for yourself.
Where's the market headed? Watch Fool contributors Morgan Housel and Alex Dumortier duke it out.
