What is the NPV of Expected Future Profits of Money Managers?∗

Although established money managers operate in an environment which seems competitive, they also seem to be very profitable. The present value of the expected future profits from managing a collection of funds is equal to the value of the assets under management multiplied by the profit margin, assuming that the managed funds will remain in business forever, and that there will be zero asset flow into and out of the funds, zero excess returns net of trading costs, a fixed management fee proportional to the assets under management and a fixed profit margin for the management company. A profit margin of 30% seems empirically reasonable, but money management companies seem to trade at 2-4% of assets under management. Attempts to reconcile the two figures are not compelling, which is disturbing considering the centrality of the present value formula to finance and economics. Another computation suggests that holders of actively managed funds typically lose about 12% (18%) of their assets if they hold the fund for 20 (30) years, as compared with a loss of less than 3% (5%) for low-cost index fund investors for similar holding periods. ∗This is an evolving draft, and comments are very welcome. email: [email protected] †Conversations with numerous colleagues at Columbia and elsewhere were instrumental to the ideas summarized in this work. I am especially grateful to Mikhail Chernov, Charles Jacklin (Mellon Capital), Charles Jones, Thomas Miles, Rick Nelson (Ing Investment Management), Doron Nissim, Ady Pauzner, Barbara Platzer, Stephen Ross, Michael Yates, Richard Zeckhauser, seminar participants at Columbia, NYU, the Graduate center of CUNY, the BSI Gamma Foundation conference on hedge funds, and the University of Texas at Austin. Jose Martinez provided insightful comments and excellent research assistance. Financial support from the BSI Gamma Foundation is also gratefully acknowledged. There are hundreds of mutual fund families, barriers to enter the money management business seem low and little capital is tied up in that business, all of which suggest that the industry is competitive and that its producers should therefore have low if not zero profits. How does the market set the price of these expected future profits, i.e., how does the market price the equity of established money management firms? Assuming that the annual rate of interest is fixed at R, consider a firm that manages a short term bond mutual fund and charges a fee at the end of each year equal to a fraction c of the assets under management. Assuming that it initially manages $A, and that the clients neither add nor withdraw money from the fund, the stream of income that the management company will receive is: A(1 + R)c at the end of the first year, A(1 + R)(1 − c)c at the end of the second year, A(1 +R)3(1− c)c at the end of the third, etc. At the discount rate R, the present value of this stream is A — the value of the assets under management. The management company uses its revenues to pay for asset gathering, retention and servicing, and portfolio management. It also pays income taxes on its profits. The rest goes to the management company’s owners. Empirically reasonable estimates of the pre-tax and after-tax profit margins are 35% and 20%, respectively. Such profitability seems difficult to reconcile with the industry being highly competitive. This back-of-the-envelope calculation indicates that money management firms should be priced at between 20% and 35% of the assets under management. But they are priced at 14% of assets under management, a pricing range which applies to both private transactions, and to ten publicly traded money management firms. It is tempting to explain away at least part of the discrepancy by invoking the risk that any given money manager may lose most or all of the assets under management for a variety of reasons, such as abysmal performance or serious legal problems. But the pricing formula also applies to the incumbent money managers collectively, not only to individual money managers. Therefore the validity of this explanation must rest on new entrants siphoning