Shares in mutual fund companies take off

Wall Street has many fascinating proverbs, such as "Don't catch a falling knife," "Let your winners run," and, "An auditor can never be too drunk."

But here's one that bears examining: "When everyone else is looking for gold, it's good to be in the pick and shovel business."

In a bull market, it's good to be in the mutual fund business.

Shares of publicly traded fund management companies — the companies that run the funds, not the funds themselves — have soared 54% this year, vs. 5% for the Standard & Poor's 500-stock index. Are there any cheap fund-company stocks left? Yes, but you might be better off investing in companies that distribute funds, rather than companies that manage them.

In nearly any bull market, it's usually more profitable to invest in the stock of mutual fund companies rather than the funds those companies manage. Let's start with the proposition that the mutual fund business is very, very lucrative. Franklin Resourcesben, for example, has a 19.8% profit margin, and T. Rowe Pricetrow weighs in with a 19.9% profit margin. computer-chip maker Intelintc, by way of contrast, has a 12.8% profit margin, and General Electricge gets by with a 9.4% profit margin.

Fund management companies earn their profits by taking a percentage of a fund's assets each year. Funds call that percentage the "expense ratio." The typical expense ratio for large-company core stock funds is about 1.2%, according to Lipper, which tracks the funds. Last year, the five largest stock mutual funds raked in about $2.2 billion in expense fees. At least someone did well last year.

A bull market has two other happy effects for fund management companies. First, a rising market increases the value of the funds' securities, which, in turn, means more income from expense fees. Consider a $1 billion fund that gains 30% in the course of a year. The fund charges 1.5% in expense fees. Management's take from the fund jumps 30%, to $19.5 million from $15 million.

The second happy effect: Investors shower funds with money during a bull market. A top-performing fund might see its assets double in a good bull market year, thanks to investment gains and new investor money. In that case, its income from expense fees will double, too.

But wait! There's more. It doesn't cost twice as much to run a $2 billion fund as a $1 billion fund. When assets rise, a fund company's profit margin rises, too. Mutual funds are run for the benefit of shareholders — hence the "mutual" in the name — but, peculiarly, fund fees rarely fall as much as assets rise. (The Vanguard Group, which has a different management structure than most fund companies, is a pleasant exception to the rule.)

Fund company stocks got clobbered in the bear market, as stock prices fell and investors fled. Ever since the stock market bottomed on March 3, however, fund-company stocks have soared. The Lipper Management Company Index has rocketed 123% since March 9, vs. 40% for the S&P 500 with dividends reinvested.

The question, then, is whether it's too late to invest in stocks of fund companies. Matt Snowling, analyst for FBR Capital Markets, doesn't see any screaming bargains out there. "The rally here in these names is overdone," he says. T. Rowe Price, for example, has more than doubled since March 9.

Another worry: Fund companies slashed expenses in the bear market, and could well start to spend more as stocks rise, Snowling says.

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