In Gartenberg v. Merrill Lynch Asset Management, a Second Circuit judge held that, to be guilty of a violation of excessive fees, "the adviser-manager must charge a fee that is so disproportionally large that it bears no reasonable relationship to the services rendered, and could not have been the product of arm's length bargaining."
The Gartenberg case went on to detail six ways a board of directors should evaluate fees. These have become known as the Gartenberg factors. Briefly, they are:
- the nature and quality of the services provided,
- the profitability of the fund to the advisor,
- economies of scale of operating the fund,
- fee structures of comparable funds,
- the independence and conscientiousness of the board, and
- fallout benefits.
Let's focus on the second factor—the profitability of the fund to the advisor.
Because the profitability of the investment management company is a topic of interest to boards of directors, it is an important factor for investment advisors and investors to think about periodically as well. Before looking at profitability trends, it is necessary to understand some of the complexities of collecting this data and the complexities of the comparisons.
Each spring since 1993, Lipper has produced its "Investment Management Profitability Analysis," which presents the pre-tax, pre-marketing profitability and pre-tax, post-marketing margins for each publicly available investment management company. Lipper collects the revenue and expense data from companies' corporate reports (specifically the 10-K section), and from these numbers calculates the profitability margins.
Revenue line items include investment advisory revenue, service fee revenue, and fund administration revenue, to name a few. Expense line items include, but are not limited to, sales and marketing, compensation and benefits, and subadvisor fees. This information is disclosed only by public investment management companies. As a result, the report currently includes 26 investment managers representing 23% of the mutual fund industry's assets.
With Lipper's historical data, we can examine median profitability margins over time (see the chart below). The green line in the chart represents the median pre- marketing profitability margin, while the blue line represents the median post- marketing margin. The pre-marketing margin is always higher than the post- marketing margin because the pre- marketing margin considers profitability as if there were no marketing expenses.
Another point to keep in mind is that there are more firms included in the post-marketing median because many firms do not disclose marketing expenses separately.
The short story is that median profitability margins for 2011 were just slightly higher than they were in 1993, but that does not tell what happened between those two years. The median pre-marketing margin rose steadily from 1993 to 2000, then decreased in 2001. From 2002 to 2007 the margin rose steadily again, but the effects of the recent economic downturn were seen in 2008 and 2009. Beginning in 2010, the median pre-marketing margin began rising again.
The median post-marketing profitability margin displayed a similar pattern, but with a few differences. The median post-marketing profitability margin fell at the beginning of the period, then rose steadily beginning in 1996.
Instead of peaking in 2000 like the median pre-marketing profit margin did, the median post-marketing margin peaked in 2001, and then began a steady decrease over the next couple of years.
Median post-marketing profitability leveled off in the mid-2000s, but then increased in 2007. Similar to the median pre-marketing margin, the median post-marketing margin decreased with the economic downturn and has increased again in the last two years.
Median profitability margins show trends over time. However, it is difficult to compare profitability from firm to firm and to judge what is relatively high or relatively low because of four complicating factors:
- The level of disclosure varies among firms. For example, some firms report one revenue item as "total revenue," and others disclose individual sources of revenue.
- Some of the companies in the study are involved in managing other assets, not just mutual funds.
- Some of the companies included in the study are involved in activities outside of asset management. For the purposes of this study, companies not primarily involved in asset management were not included. But firms that have small profits from other sources were included.
- The type of asset classes managed may affect profitability. For example, money market funds may affect profitability differently than do equity funds.
Despite these limitations, profitability is an important consideration for investors and investment advisors. It can help investors and investment advisors judge whether or not a firm has the ability to invest in its own business, one indication of the soundness of the business.