Conventional wisdom holds that smart investors don’t buy mutual funds; they buy the fund companies’ shares. In the past, that strategy may have worked. But fund-company stocks may be in for a rougher ride in the future, as firms grapple with the evolving competitive landscape.

The rationale for owning shares in fund companies rather than their funds is that, over time, any given mutual fund has a hard time consistently beating the index, especially given the management fees. Better, it is thought, to own a chunk of those fees — paid regardless of performance — by owning stock in the fund companies.

This strategy has been borne out — most publicly traded fund companies have enjoyed spiralling stock prices, and several firms have been acquired at healthy premiums.

Now, however, the competitive landscape has shifted to such a degree that fund companies may not be the sure thing that they were in the past. A new report from BMO Nesbitt Burns Inc. points out that in order to stay competitive, fund companies are being forced to get into the business of providing their distribution networks with trust services and banking products. Compared with straightforward asset management, these are lower-margin activities that may ultimately weigh down fund managers’ valuations.

“The rise of the banks is forcing the independent operators to offer more trust products,” says the report. “This raises an interesting dynamic that, while banks and [life insurance companies] are expanding into wealth management as an offensive strategy to increase fee-based, higher return-on-equity businesses, the fund companies are expanding into spread-based, more capital-intensive, lower-ROE businesses as a defensive strategy. More modest growth rates, rising competition and potentially lower-ROE businesses could translate into more modest valuations in the Canadian fund industry.”

At this point, fund company valuations are near their historical highs, the report notes, a result of strong asset growth over the past few years, low interest rates and rich valuations for similar businesses that have gone public in recent years.

However, the mutual fund business is still evolving. And, as the report points out, that means fund firms must adapt to the changing environment: “We believe that progress in the Canadian mutual fund industry would have seen the major fund companies experiencing greater domestic consolidation, U.S. and/or international expansion and increased penetration into other investment-management segments (i.e., institutional and/or high net-worth).”

But, for the most part, this hasn’t happened. “Domestic consolidation has been slower and less pronounced than expected,” the report continues, “international expansion has been very modest, if at all, and only recently has the industry expanded into the high net-worth or institutional segments.”

Several Canadian fund companies have made limited forays into the U.S. and British markets. But the appeal of these markets has been limited by the fact that they are highly competitive and offer tighter margins. The Nesbitt report notes lower fees and margins, likewise, have kept mainstream fund companies out of the HNW and institutional asset-management businesses. The cost of cultivating these markets has not necessarily been worth it, particularly when the fund companies’ traditional fund business was strong.

In recent years, however, those conditions have shifted. According to the report, the average annual growth rate for the core mutual fund business from 1990 to 2000 was 32.6%. Yet, between 2001 and 2006, that dropped to just 8.2%. More recently, industry growth has revived somewhat. The latest data from theInvestment Funds Institute of Canada indicate that asset growth over the 12 months ended Sept. 30 is roughly 15%, with net sales contributing about 40% of that.

However, this isn’t likely to last. When the fund industry was growing quickly, both markets and sales were booming. Now, with industry assets under management at more than $700 billion, it’s that much harder to sustain those heady growth rates.

Markets have been particularly strong recently, but, over the long run, markets may well offer more modest support to industry AUM. Indeed, the Nesbitt report presumes that AUM will grow by 6%-7% a year on average over the next five years because of rising markets, with net sales good for another 2% to 3% of annual growth in AUM.

Although this is still a decent organic growth rate, traditional fund companies can’t necessarily count on catching their fair share of it, as the banks continue to capture an increasing portion of the business. The banks, notes the report, have taken their share of long-term AUM to more than 30% from 18%-20% in the late 1990s. Moreover, they are now capturing more than 40% of long-term net sales.

@page_break@The toughest competitor among the banks has been Toronto-based RBC Asset Management Inc. , followed to a lesser degree by TD Asset Management Inc. , also of Toronto. One of RBCAM’s key strengths is its portfolio products — a niche that now accounts for more than half of fund sales. According to IFIC, in the first nine months of 2007, packaged funds generated 64% of net sales, or $18 billion worth.

Although RBCAM has led the banks’ fund industry insurgency, Nesbitt expects the other big banks to improve their offerings as well. With slower growth and more competition from banks and other investment products, Nesbitt expects fund firms to face increasing pressure on their fees and margins.

Given this sort of competitive landscape, the traditional fund companies will have to do more to stay popular with third-party advisors, the report says: “Over the next three to five years, large fund complexes, in order to remain competitive, will need to offer an attractive array of bank-like products in order to generate significant sales through the independent financial planner channel.”

However, this is easier said than done. The recent deal between Bank of Nova Scotia and Dundee-Wealth Inc. — which saw Scotiabank take a stake in Dundee and buy the latter’s banking operation — was motivated, in part, by the trouble that Dundee’s new banking arm ran into when the credit crunch seized up the asset-backed commercial paper market. The ABCP market served as an important source of funding for a number of non-traditional lenders, and its disruption highlights the importance of the form and substance of funding sources in traditional banking businesses.

The Nesbitt report identifies the mutual fund companies’ funding model as one of the key considerations when looking to launch a trust business: “Overreliance on high-interest deposits and securitization is troublesome. The best option appears to be sourcing fixed-term GICs via the [investment and mutual fund dealer] channels at modest premium yields to the bank rates.”

Apart from securing funding, the report sees the other keys as distribution and developing the right products. “We believe that a trust operation should focus on certain key products that are important to an [independent advisor], specifically mortgages, investment loans and GICs,” it says, adding that these products need to be targeted at dealers (to deepen the relationship between the fund firm and the sales rep), with clients being serviced electronically — rather than offering products to the public through physical branches.

Fund industry analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. , agrees that there is indeed value for clients to be able to buy banking products from their financial advisors. “It’s not just a convenience and time-saving issue,” he says. “When people have developed a certain level of trust, they like to consolidate their business.”

Although Hallett doesn’t see the ability to offer banking products as an absolute must for advi-sors, he does note that it removes a reason for clients to walk into a bank branch, and it’s a revenue source, albeit small, for advisors. “I wouldn’t characterize it as a necessity for advisors,” he says. “But for any advisor able to sell bank products, it’s a nice feather in his or her cap.”

It’s also not an absolute must for fund companies, Hallett maintains, although the alternative is delivering sustained investment outperformance. “At the end of the day,” he predicts, “you will have larger companies that offer lots of different funds, mortgages, an investment loan and/or a savings account — and those that just want to manage money.”

Both integrated fund firms and niche players will have their place in the market, Hallett says: “The niche players can survive just fine, and a firm like Sprott Asset Management Inc. of Toronto is a perfect illustration of this — deliver great returns and you need not do anything else to earn client and advisor loyalty. But the banking products and other stuff can certainly save a fund company’s bacon if performance doesn’t stay in chart-topping territory.”

Along with developing banking-product offerings as a way of staying competitive, Nesbitt also expects the mainstream fund companies to continue expanding into the areas that they have eschewed in the past — HNW and institutional clients. However, it doesn’t see this as a meaningful source of additional earnings in the immediate future.

The opportunity for further industry consolidation also remains a factor in fund company valuations. The Nesbitt report suggests that the consolidation of the Canadian fund industry is not over, but that it is probably in its later stages. Given the lack of acquisition targets and the ability of potential buyers to wring significant synergies out of further consolidation, it predicts that the remaining firms will still exact a premium if they ever decide to sell out.

The possibility of rich takeover deals notwithstanding, the fact that slower growth is pushing fund companies into less lucrative businesses means that, in future, the shrewd investor may be better off owning fund companies’ best products rather than owning their stocks — a stark turnaround from the smart strategy in years past. IE