Changing Dynamics Of Regulation – The Sunset by Sui Generis
Very few industries actually suffer the same fate as the proverbial buggy whip, that is to say extinction. We wanted to lead with that proclamation because the term “disruption” is bandied about so often that one couldn’t be blamed for thinking that various businesses were becoming antiquated at an alarming rate. But the truth is that most do not die, they simply evolve and survive in a form that may only loosely resemble what they used to be. So while industries rarely become extinct the way the buggy whip did, products often do. An easy example would be photography where the digitization of taking pictures sent the likes of Eastman Kodak and Polaroid into bankruptcy. Given that our knowledge of today’s youth is limited to the fact that more often than not they seem to be taking pictures of themselves, we may suggest that the industry is alive and well and more photos are taken now than ever before. Time and technology change industries, often for the better, and unfortunately leave behind certain products and the companies that create them. By now you’re likely asking “where are they going with this?” as we’ve now established that we aren’t going to be writing a requiem for an entire industry but rather a specific product that is being disrupted.
There are few sectors that the team managing Sui Generis Investment Partners will claim to know intimately. We stick to what we know and believe that this is the best way to drive returns for the investors in the Fund, so far so good there. With that in mind both industrials and manufacturing are well represented in our portfolio. We know energy very well; we understand mining at a very respectable level though we aren’t fans of the fact that both industries seem to consume capital at alarming rates. But the sector in which we find investment opportunities on the most consistent basis is perhaps the most obvious as it’s the only industry we’ve ever worked in, that of course is finance. Now before you assume that we’re going to write some bullish defense of our industry over the subsequent pages (because, why would anyone slag their own industry?) we’ll have to cut you off right there and finally get to the point. The investment management business is undergoing seismic changes in Canada, and the product that we believe has already begun spiralling towards obsolescence is the mutual fund.
Changing Dynamics Of Regulation
We hold very firmly the belief that private investors will continue their mass migration towards lower cost exchange traded funds; henceforth referred to as ETF’s for the uninitiated, and you’re now duly warned that we will be throwing around a few acronyms in this note. As well, we believe that this migration process is about to accelerate in Canada, in essence playing catch-up with what has already happened in the United States. The reason as one might expect is money, more specifically too much of it being paid to fund companies and their managers for doing little more than mimicking a particular index. Why invest in a mutual fund whose management expense ratio (the total cost to manage the fund, also known as “MER”) is 2.2% vs. an ETF at 0.40% when both products ostensibly do the same thing? Why then do mutual fund investments in Canada still dwarf ETF’s by 12x? Once again, the reason is money. Investment advisors across the country are routinely paid “trailer” fees by fund companies to distribute their product. A trailer fee is an annual cash payment to the advisor for investing their clients in particular fund and this fee typically runs about 1% annually on equity funds. While to those outside the industry they may look suspiciously like bribes, there is nothing sinister about trailer fees in and of themselves, they’re simply a way for fund companies to win the favor of advisors across the country…by paying them cash. But a paradigm shift is coming to the Canadian brokerage industry via new regulation known as CRM2.
CRM2 introduces new requirements for client statements, charges and compensation disclosure, and performance reporting. These amendments came into force on July 15th, 2013 and are phased-in over a three year period, with the final phase effective July 15th, 2016. CRM2 focuses on the trailer fee being paid to the broker and does not disclose in the fee calculation in the MER of the underlying mutual fund. This has angered many brokers we have interviewed as they feel they are the ones being targeted by the new requirements, not the mutual funds as they were previously lead to believe. The core principal behind the new regulation is to provide the investor with a clear view of what they paid their broker and what they received in return. Both of these numbers are to be represented in real dollar amounts rather than percentages for the first time ever.
So how will these new disclosures change the habits of the brokers? They’re in a challenging position when being confronted by clients on fees and performance as they have really three choices should they to wish to maintain the client relationship. 1) They can reduce their own fees 2) they can switch money allocated to poorly performing funds into funds with better track records or 3) they can attempt to find lower cost product, or put another way, they will lower the fees of fund companies rather than their own. We believe the importance of this dynamic and the magnitude of the move coming has been grossly underappreciated by analysts who cover the fund companies. Of the choices we just highlighted, option one is a non-starter for a long as possible so you’re left with options two and three, a dynamic that we believe will conspire to irreparably harm the mutual fund companies.
Now that we’re familiar with the regulatory backdrop we want to focus on performance because now more than ever the investment business is about performance. Imagine the broker pointing out to his client the healthy trailer fee he has been receiving for allocating that client’s capital to a particular mutual fund, then explaining that the fund has underperformed its peers or done no better than the market. It’s an awkward conversation as we believe it will be at this moment that many clients will realize that their brokers are conflicted. Client’s will soon be asking for a fundamental justification and that doesn’t bode well for the asset growth of mutual fund companies, particularly those with poor performance. This leads us to the actionable part of the thesis, identifying the public company whose name should come up more often than any other in the preceding example, CI Financial (CIX-T).
CI Financial is one of the largest asset managers in Canada with an enterprise value of $8.2 billion and a core business that manages $108 billion and the majority of CI’s revenue is earned via fees for the management of mutual funds. These products are distributed through brokers, independent financial planners and insurance advisors. The value proposition for mutual funds has historically been very simple; provide a pooled wealth management solution that delivers asset appreciation over time to smaller investors that could not afford such diversification on their own. Money should naturally flow into funds that demonstrate an ability to deliver above average returns and flow out of funds that don’t. Now that we’ve given you an incredibly quick biography we’ll explain to you why we’re short the stock, starting with performance.
Mutual funds are often ranked in quartiles based on their performance, with the 1st quartile representing the top 25% of funds in the country and the 4th quartile representing the bottom 25% while anything below 2nd quartile represents below average. The progression of CI’s performance ranking is troubling for their investors and the advisors who continuously allocate money to them. The 5, 3, 2, and 1 year performance quartile ranking for CI’s 30 largest funds (representing $80.7B dollars or 75% of the AUM total we mentioned above) are 2.8, 3.0, 3.2 and 3.4 respectively…and yes like golf a higher number isn’t a good thing. Eventually money will begin to flow away from poor performance as brokers will no longer be able to justify allocating client money towards expensive poorly performing funds simply because CI pays them to do it. The average MER of those same 30 largest funds at CI is 2.2%, while the MER for the 30 largest ETF’s offered by iShares, the world’s largest ETF provider is 0.4% (see, those numbers earlier weren’t random). For good measure another popular ranking tool for mutual funds is provided by Morningstar, a firm specializing in analysis of mutual funds. Morningstar rates funds on a 5 star basis with a 1 star fund being the worst-rated and 5 star being the highest; we apologize but yes it’s essentially the quartile system flipped upside down. Only 20.5% of CI’s funds are rated 4 or 5 stars and the average Morningstar rating for those same 30 funds we mention above is 3. So put another way, we think it would be appropriate to think of CI as the C- student of the mutual fund industry…a perfectly nice guy but perhaps not the student you want to hand your life savings over to.
From Every Direction
So the performance is poor but money invested in long-only funds still needs to flow somewhere and we believe that will increasingly be towards the new kid in town, the ETF. In what we believe is a sign of things to come, Canadian mutual fund net sales declined 58% in Q1 of 2016 against an increase of 13% for ETF’s. This competitive pressure is coming at a very inopportune time given the performance numbers we just showed you. The digital cameras to the mutual funds’ Kodak, ETFs are keeping retail investors exposed to stocks and bonds, but in a more efficient, low cost way. ETF’s have attacked the generic investment mandates such as “Canadian Equity” or “High Income” where they can deliver what is effectively the same product at a fraction of the price, great news for investors! This is of course troubling for mutual fund managers for two reasons; it’s tough to distinguish yourself in those mandates as all funds are effectively holding the same companies (Canada being the small market that it is) and secondly these “generic” mandates amass the greatest amount of assets and provide the most profit for CI et al…and now they can’t hold price.
That’s an important point here as this heating up of competition doesn’t mean much to this thesis without causing some margin compression, so let’s look at how CI is holding up. On one of our favorite metrics is a firm’s annual “management fee per $1 million of AUM” and since 2011 CI’s is as follows: 2.07%, 2.00%, 1.95%, 1.90% and 1.87% last year, Q1 of 2016 showed .43% or an annualized 1.72%. So the compression actually began in 2011. We believe that this progression is about to accelerate given that performance tends to be a leading indicator for sales in the investment business, and with the performance rankings we showed you above, we don’t think CI’s Q1 net investor redemptions of $330 million and AUM decline of $1.4 billion in their core business were an anomaly, we think they were the tipping point. For more proof of this concept, contrast CI’s bleak sales scenario with that of Fidelity, a shop that in Canada is smaller than CI representing 7.8% of the Canadian mutual fund market. In Q1 Fidelity represented a staggering 34% of all mutual fund net sales at $3.8 billion. How could Fidelity punch so far above their weight? Are they giving their services away? Of course not; As we mentioned before performance matters now more than ever to brokers allocating their client’s capital and 95% of Fidelity’s AUM is rated either 4 or 5 star by Morningstar (compared again to CI’s 20.5%).
Positive or negative performance notwithstanding, we often question how much longer mutual funds will exist in their current form? Alpha and absolute performance is the realm of hedge funds; beta and relative performance is the playground of the ETF now, so why do you need expensive beta? Interestingly, ETF products are getting more sophisticated with products like “smart beta”. We dare you to google it and understand what this term actually means as it sounds a lot like alpha to us, nevertheless it seems like a powerful marketing gimmick. It was reported last week that ETF’s commanded a 15% market share in the US and the same report suggested that number could grow to between 40% and 60% over the next 10 years. In Canada, ETF assets are equal to only 7.6% of mutual fund assets, up from 6.8% a year ago and clearly playing some catch up with the US.
So in an attempt to jump on board this trend in 2015 CI Financial purchased First Asset Management, a provider of ETF products in Canada. In a recent sell-side report the analyst noted “management stated that over time it was conceivable that First Asset could grow its AUM from $2 billion to $10 billion.” The question is…how can the ETF unit grow by 5X while the mutual fund business remains intact? The answer of course is that it can’t. We don’t believe for a minute that First Asset is going to win market share from the iShares behemoth backed by the world’s largest asset manager, Blackrock. And we’ve shown you that CI’s mutual fund business has already stopped growing…so we believe that if that growth projection is somehow correct, CI’s best case scenario is that they swap a bunch of 2.2% business for 0.4% business, or in other words CI is in trouble.
Why We’re Short (Yes, More)
All of this information being publicly available, you’re probably assuming that the stock has been beaten up and this scenario is already priced in. We would respond to that by suggesting that we believe CI is the most expensive asset manager in North America or in other words, it’s not even close to being priced into the stock. The only valuation metric that we care about when it comes to asset managers isn’t P/E or EV/EBITDA because as we have demonstrated above, earnings and EBITDA can be fleeting. EV/AUM is the most reliable metric for valuing asset managers over the long term as it’s the metric used by the industry when considering takeovers. On this metric, CI trades at 7.5% of its AUM, the highest of 18 publicly traded comps we have looked at. For context, the average small and mid-size US asset manager (CI’s most logical comps) trades at 1.7% of AUM while the larger asset manager group in the US trades at 1.9% of AUM so CI is about 4.4x more expensive than it’s US peers on our preferred metric. Amongst Canadian peers it’s still the most expensive but the average valuation (ex-CI) is higher at 4.14% of AUM. In the interest of full disclosure, CI is not the only Canadian asset manager our fund is short, most of them are expensive, particularly against the backdrop of our earnings decline call over the coming years.
So why is this the case? Investing in Canada is far more expensive for the retail investor than in the United States but we believe CRM2, ETF’s and weak performance will fix that problem soon enough. If long-only fund investing is to get cheaper for Canadians the margins achieved by Canadian asset managers will soon come in line with their US peers (this would represent a margin decline of over 60%). The other issue is that CI is one of the larger commission payers to investment banks in Canada and we can’t imagine a scenario where an analyst writes a note suggesting his clients sell CI Financial stock and expects to still have a job going forward. So the street is littered with buy reports on a stock where we see extreme competitive pressure, poor performance from the underlying business, an increasingly challenging regulatory backdrop and a very expensive valuation. We hope this has shed some light on a topic we find fascinating and we encourage you to follow up with us if you care to learn more about the work we have put into the subject. The sun is just beginning to set on the Canadian mutual fund business and CI Financial and just like every sunset you’ve ever sat and watched, it’s going to be dark before you know it.
The Sui Generis Team