An Uneasy Rebound for Fund Companies

Asset managers who performed best since the market melted down should benefit, but competition from ETFs is squeezing actively managed funds

By David Bogoslaw

To a great extent, all actively managed equity mutual funds have benefited from the stock market rally over the past three months. Fund inflows have rebounded dramatically and stock prices of the asset management companies themselves have roughly doubled since Mar. 9. But enthusiasm toward stocks has cooled in the past two weeks as the markets more carefully weigh the considerable obstacles that the U.S. economy needs to surmount before it can return to health.

While the pace of money flows into equity mutual funds seems to have picked up in June from April and May, that's probably a bearish sign for stocks, according to TrimTabs Investment Research in Sausalito, Calif. That's not only because the amount of cash on the sidelines has been reduced, but because mutual fund investors tend to invest heavily in the late stage of rallies, says Conrad Gann, president of TrimTabs.

Daniel Fannon, an analyst at Jefferies (JEF) in San Francisco, sees all mutual fund managers benefiting from the positive momentum in equity markets of late. The May data for net inflows to mutual funds show that when investors piled back into equities as the rebound from early March continued, they didn't make much effort to distinguish between good and bad asset managers, he says.

"That's not sustainable, even if [equity] markets are flat from here" over the next six months, he says. "People will be choosey with where they're putting their money. There will be greater focus on relative performance, on one-, three-, and five-year numbers."

second-quarter operating margins

Fannon expects certain asset managers with superior returns year-to-date to gain market share as investors start to reward better performance. Among the likely winners, Invesco (IVZ) stands out as a result of how well it performed on a relative basis in 2008 and even in the early months of 2009. Waddell & Reed (WDR) should attract new money, given the superior returns earned by its Ivy Asset Strategy Fund (WASAX) and Ivy Global Natural Resources Fund (IGNAX) so far this year. Janus Capital (JNS) has a broader range of funds that have done well this year and there are some T. Rowe Price (TROW) funds with impressive returns as well, he adds.

Another way to differentiate these stocks will be to compare operating margins in second-quarter earnings, says D.J. Neiman, an analyst at William Blair in Chicago. "The firms have done head count reductions of 10% to 12% to right-size their expense bases to current market reality levels and revenues levels," he says. "We'll see how quickly operating margins can snap back since moving from the lows" earlier this year, he says.

Growth in the mutual fund industry and among individual publicly traded companies will come mostly from investors outside the U.S. over the next decade, he predicts. That should benefit Invesco, Franklin Resources (BEN), and BlackRock (BLK), all of which have a bigger portion of their assets coming from non-U.S. investors.

Most of the gains in assets under management that have resulted from stock market appreciation are expected to fall directly to the asset managers' bottom lines in the second quarter, analyst Kenneth Worthington said in a JPMorgan Chase (JPM) outlook report for the second half of 2009, published in June.

Invesco's money market funds gained

Invesco is Worthington's favorite pick of the group over the next six months, thanks to the uptrend in stocks and strong appreciation in the Canadian dollar and the British pound. With foreign markets recovering faster than the U.S. market, Invesco's greater international exposure should be a plus, even apart from the currency effects, he said. He expects Invesco's management to be on the hunt for ways to increase earnings in the current market, which even in a flat market should boost the firm's earnings growth above that of its peers and drive up its price-to-earnings multiple.

Invesco's ability to gain market share for its money market funds in a declining money market industry also makes the company attractive, according to Credit Suisse (CS) analyst Craig Siegenthaler. In a June 10 research note, he cited $5.4 billion of net inflows in May into Invesco's money market funds.

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