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Which fund management company should you own?

It’s well known that fund management companies record much higher profits when the market is buoyant. This is because fund managers usually charge a management fee that is a percentage of their funds under management (FUM). When the market is up, fund managers invariably have more FUM, because the funds they are managing have grown through increasing investment returns.

A secondary effect of a rising market is that investors (for all the wrong reasons) are generally less likely to withdraw funds during a period of strong returns. Once the music stops, FUM can take a dive as investment returns turn negative and investors withdraw money. It’s fair to say that fund management is a cyclical business.

As Motley Fool contributor Peter Andersen writes, Macquarie Group (ASX: MQG) has improved earnings consistency with its shift towards funds management. Not only that, the profligacy of IPOs and positive sentiment is a positive for Macquarie’s investment banking business. Should the current optimism continue, Macquarie is very likely to grow profits.

Macquarie is worthy of consideration because the company was able to withstand the GFC while one of its major competitors went out of business. However, some commentators have suggested that the “millionaire factory” has overpaid executives in the past. The same cannot be said for boutique funds management company Fiducian Portfolio Services (ASX: FPS).

Fiducian has a network of in-house financial advisors and franchisee advisors. However, about 70% of its revenue comes from its boutique funds management business. Fiducian may not be the brightest star in the funds management universe, but the company has recorded reasonable results over the long term. Its most successful fund, which invests in smaller companies, has returned an average of 10.9% p.a. over the last 10 years. The Fiducian Australian Shares Fund has returned 9% p.a. over the same timeframe.

Fiducian’s cash flow statement for the quarter to September 2013, released today, reports net operating cash flow of over $1.8 million. That’s not bad for a company with a market capitalisation of under $40 million. Fortunately for shareholders such as myself, the company has a good history of paying dividends, and trades on a trailing yield of 5.9% fully franked. I consider Fiducian Portfolio Services to be attractive at current prices.

Another fund manager trading on an impressive (trailing) dividend yield is Hunter Hall (ASX: HHL). Hunter Hall manages the listed fund Hunter Hall Global Value (ASX: HHV), which is up about 17% in FY 2014. Hunter Hall’s unlisted Value Growth Trust has returned 7.4% p.a. in the last 10 years and its Australian Value Trust has returned 5.5% in the same timeframe.

Hunter Hall (the management company) has a market capitalisation of about $60 million and trades on a trailing yield of about 8.2%, partially franked. In 2012, the company hired David Deverall as the new managing director. Deverall previously led blue chip fund manager Perpetual (ASX: PPT). While Perpetual does have a very strong brand, the company yields less than the other fund managers mentioned in this article. Perpetual currently has a trailing dividend yield of about 3.6%, fully franked.

Foolish takeaway

Investors should be wary of buying shares in a fund manager during times of market optimism. A strong yield will provide comfort to long-term investors, as it would be unwise to sell during market turmoil when the share prices of funds managers inevitably fall. On the other hand, if you sell at the cyclical peak, large profits can result.

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Motley Fool contributor Claude Walker owns shares in Fiducian Portfolio Services. .

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