It is no surprise that Charles Schwab is trading at 52 week lows: as long highlighted, for retail brokers to make money, someone has to trade. And since Schwab can't charge the computers, the banks, and the Fed for transactions (especially the latter which seems to enjoy dark venues more than anything), the future is sure not bright for the E-Trade's (potentially the only investment in Citadel's portfolio, which is for the second year in a row below its high water mark, making money this year) and the Schwabs. Yet due to their relatively lean cost structure, retail brokers at least do not have to worry much about redemptions and capital under management. Which is most certainly not true for the mutual funds out there, many of which are also public, and will soon be whacked doubly more so as a result of plunging asset holdings, and tumbling transactions. So instead of shorting Schwab, here are the mutual funds, classified courtesy of Moody's, which have the most to lose from the ongoing $50 billion+ YTD withdrawal by investors from domestic stock funds (hint: Waddell & Reed, and Janus).
But first some narrative:
In data released last week, year-to-date flows into bond mutual funds moved over the $270 billion mark during the week ending 18 August, according to EPFR Global, a mutual fund research firm. Investors’ voracious appetite for fixed-income mutual funds has only increased in recent months. For asset management firms such as Janus and Waddell & Reed that are weighted toward retail equity mutual funds, the preference for fixed income is credit negative. But the trend also carries negative implications for the industry as a whole, because asset manager profitability will be challenged as lower-fee fixed-income assets become an increasing percentage of the underlying mix of assets under management (AUM).
Retail investors are moving out of higher margin equity products and into lower margin fixed-income products. We estimate that top-line revenue declines by approximately $1 billion and pre-tax income by approximately $250 million for every 5% of industry mutual fund assets that move from equities to fixed-income. Given the much higher fees on equity mutual funds, an asset manager needs a higher base of fixed-income assets just to achieve the same level of profitability.
US retail mutual fund investors, nervous about sluggish growth and high unemployment, have shown a decided preference for bond mutual funds at the expense of equity mutual funds since late 2007, as shown in Exhibit 1. As of the end of the second quarter 2010, absolute assets under management at asset management firms were close to the peak AUM levels seen in the fourth quarter of 2007 and early 2008; however, the underlying mix is now weighted more heavily towards lower margin fixed-income products. According to the Investment Company Institute (ICI), bond mutual funds have attracted more money than equity mutual funds for 30 consecutive months through June, the longest stretch in more than 23 years.
For asset management companies like Janus (Baa3 negative) and Waddell Reed (Baa2 stable) whose businesses are skewed toward retail investors, this extended flow trend poses more concern because these firms lack scaled fixed-income platforms to offset increased outflows from equity mutual funds. Increased risk aversion among retail investors poses the greatest challenge for these two firms’ AUM position because of their higher sensitivity to retail investors and equity markets.
Firms with stronger global fixed-income franchises such as Legg Mason (Baa1 stable), BlackRock (A1 stable), and Franklin (A1 stable) will be greater beneficiaries of a continuation in this flow trend and their gains in fixed-income AUM will help soften negative impacts from increased equity fund outflows. Additionally, the improved operating environment for asset managers since first quarter 2009 has helped most asset managers, including Janus and Waddell & Reed, to strengthen their balance sheets and position them to weather this trend and/or address gaps in their product line-ups.
If this flow trend holds, the asset management industry’s profitability will be challenged. We believe this trend has no near-term credit implications but that its protracted extension is more likely to have negative credit implications on asset managers with asset mixes more skewed toward retail equity funds.
And here are the biggest losers from the ongoing boycott, sorted in order of decreasing reliance to equity. Our condolences to Janus - it is not too late to buy up some Cajas and some Greek banks and to try to pass off for a TBTF.