Right now, even though we’re in a very powerful bull market, morale is low at Canada’s 2^nd largest asset management firm: Investors Group. This firm’s AUM has fluctuated around the same level for 8 years while peers have seen growth.

I know many people who worked at IG, including a very close friend and several acquaintances, plus they all know each other. This allowed for some good scuttlebutt. After keeping track of the story for years, the valuation + catalysts are nicely lined up now for shorting IGM. I estimate IGM can go down 30% easily and 50%+ when things turn really ugly. 

Summary

Investors Group is a terrible Canadian asset manager. Enough bad things cannot be said about this company. They are despised by many former clients and former ‘consultants’. Its top earners are leaving to other firms. Its fees, client treatment and internal incentive structure are disgusting even by Wall Street standards. Its franchise value has been deteriorating for many years and I expect things to get much worse. And when AUM shrinks, things can get non-linear. My recommendation is to short the parent company, IGM Financial, which owns Investors Group, Mackenzie Investments (another mutual fund company) plus miscellaneous activities. 

Mackenzie was purchased in 2001 and the culture/products are better but it doesn’t affect the thesis much because they also have substandard AUM growth. The short thesis has the following components:

-          IGM experiencing Secular AUM underperformance vs. peers

-          Secular decline of the whole mutual fund industry vs ETFs

-          Downside sensitivity because asset manager performance is leveraged to securities’ markets performance

-          Strong catalysts for a potential bear market - especially in Canadian stocks

-          Record personal debt levels inCanadaportending a future need to redeem mutual fund money, which will happen when the Canadian housing bubble implodes, something that itself now has strong catalysts.

Investors Group Business Description

IG sells mutual funds. They also act as a reseller for mortgage and insurance firms so that they can be a “one stop shop”. The mortgage business won’t be discussed here. It isn’t that small, butCanada’s housing bubble is pretty exhausted so this division is just gravy on top of the main thesis.

The mutual funds are divided into 3 kinds: in-house, funds from partner managers that IG resells with higher management fees and “portfolio funds” where they mix things up for clients according to the given portfolio allocation criteria. From the annual report:

At December 31, 2012, 44% of Investors Group mutual funds (Investors, partner and portfolio funds) had a rating of three stars or better from the Morningstar fund ranking service and 16% had a rating of four or five stars. This compared to the Morningstar universe of 65% for three stars or better and 27% for four and five star funds at December 31, 2012. Morningstar Ratings are an objective, quantitative measure of a fund's three, five and ten year risk-adjusted performance relative to comparable funds.

Note that it’s the partner funds that save their image. Their in-house funds are mostly 1 or 2 star. And the ‘consultants’ are incentivized to sell the in-house funds.

IG Company Culture

IG has 108 region offices acrossCanada. At the end of 2012, they had 4,518 ‘consultants’ vs. 4,608 at the end of 201l. The consultants: they are people who, in the best case, took the Canadian Securities Course (a very simple test). IG does not offer equities, only mutual funds. Most consultants therefore have very low financial literacy. I personally have known around 10 consultants (including a very close friend) and can testify to that. Here’s a quote from my friend on this subject:

“the level of knowledge is appalling for some of them...no clue of anything. Most dont even know what the FTSE is or how the S&P500 NASDAQ and Dow Jones differ from one another”

So most IG consultants understand equity markets to the same extent that telemarketers who were selling 2/28 mortgages understood the fundamentals of homeownership and debt. The consultants are given little to no training about financial matters. They are shown the products and are told this is what they must sell. My friend who worked there for 7 years got a job at a bank and promptly realized that at IG he got basically no education about markets - and this new job was one of assisting a mutual fund wholesaler, nothing too fancy. They approach potential customers (often via telemarketing) by highlighting the fact that they offer a complete solution and very often lure people by offering a free seminar on how they can save taxes. Consultants are free to do their own telemarketing (for example hire telemarketers) and their own seminars with their own presentations.

Perhaps half of consultants stay on for 3-12 months before quitting. In these cases, IG will obviously often keep the clients the consultants brought in (like their families). One big reason for people staying is the DSC, which locks people in (more on that later). Consultants have to pay IG to be part of an office. Commissions when they bring new assets are in the 2-3% range and no more than 0.5% for every year thereafter.                  

There is also an MLM aspect to IG. Managers or “division directors” get paid bonuses per new consultant hired. So if the manager is in a bad period, he’ll go out and hire people and get paid around $2,000 per head. IG recruits in every way including Craigslist. Actually, about a decade ago, I was myself recruited and went to the “job interview” for research. It was quite sleazy. Not every office is sleazy to the same degree but overall HQ gives the offices a lot of discretion. Leading up to 2008, consultants got a lot of clients to take out home equity loans with a partner bank to invest more money. I heard about portfolios with as high as 10:1 leverage. But mostly, consultants know little or nothing about financial planning and generally give the company a bad name. You can find tons of testimonials online on IG. Here’s one:

“We couldn’t get the answers to our simplest questions, the fees were never explained, the “financial analysis” she provided was rife with basic errors and bad math despite her giving it three tries.”

And here’s a quote from my friend:

But many peoples retirement went out the window because they leveraged their homes in 2007 to invest in market and then lose 40% of their portfolios and were financing all this by cashing out of their RRSP's. Classic IG strategy and completely unheard of in the big firms (Woodgundy, Dominion Securities Nesbitt etc). 

In addition to the above, there is also a brainwashing component. Many IG consultants - especially those that make just enough to keep going but are not the shrewdest – blindly believe IG is the best, mostly because of the “one-stop shop” idea that IG is there to take care of the customer from all points of view. In my view, the fact that consultants come from outside the financial world is the primary reason this happens. These people are recruited randomly and don’t know what the rest of the financial world looks like, so they aren’t sensitive enough to the importance of returns vs. fees, portfolio manager competence etc’. It is very widely reported that IG repeats the mantra to its consultants that some people in the world will say bad things about IG but “these people don’t understand”. I personally know a friend of my friend who is quite the kool-aid drinker. His mother, who worked at that office too, was demoted from manager to something more secretarial, and then she left, and he still stayed! I will paste a passage I found online from a former consultant:

They grab all the names they can see and put the names into a big excel file then the "callers" start going down the list one by one inviting them to an information session night

About the consultant position, in short:
1) 100% commission
2) Unless you are good at sales (the job is literally 99% coldcalling), you wont make it.

They hire people on a commission to get their contacts, knowing 99% of all employees they hire will fail (hence the pay on commission) and once you run out of contacts your gone

For contrast, here’s the company’s description:

The comprehensive approach to financial planning, provided by our Consultants through the broad range of financial products and services offered by Investors Group, has resulted in a mutual fund redemption rate lower than the industry average.

Investors Group combines a number of interview and testing techniques to identify individuals who demonstrate a blend of experience, education and aptitude that makes them well suited to becoming successful financial planners.

So basically we have a company that has less intelligence in its hallways, a lack of control between adjacent layers in the hierarchy, worse products, higher fees, and employees/consultants that are incentivized primarily to bring in new business and to not care about existing business. Technology-wise things are quite outdated as well. Last I heard, they still had paper statements - abnormal for a firm this size.

Mackenzie Financial

Mackenzie’s funds are better but the AUM trends are also below-average. This PDF gives a quick look at the total AUM for IGM:

http://www.igmfinancial.com/en/investRelations/finReporting/files/2012/annReport/financial-highlights-e.pdf

Compare this with another Canadian mutual fund manager, CI Financial, who between 2007-2012 had the following AUM figures ($billions):  67.2   52.8   64.2   72.8   69.6   75.7 

Still, for reference, and to give the little credit they deserve, here’s a description of Mackenzie’s ratings:

Long-term investment performance is a key measure of Mackenzie's ongoing success. At December 31, 2012, 63% of Mackenzie mutual funds were rated in the top two performance quartiles for the one year time frame, 56% for the three year time frame and 57% for the five year time frame. Mackenzie also monitors its fund performance relative to the ratings it receives on its mutual funds from the Morningstar fund ranking service. At December 31, 2012, 83% of Mackenzie mutual fund assets measured by Morningstar had a rating of three stars or better and 48% had a rating of four or five stars. This compared to the Morningstar universe of 79% for three stars or better and 43% for four and five star funds at December 31, 2012.

Mutual fund business in general

Though most people here need no explanation of this, not only are the numbers for underperforming mutual/hedge funds in 60-90% area in recent years, but also it has been found that outperforming mutual funds subsequently drop to underperformance more frequently than would be suggested by random chance! So ETFs are not only doing better on fees and returns but also reliability.

Then, add the fact thatCanada’s MERs are among the highest in the western world and within Canada, Investors Group is near the top of the pack. These fees must decline over time. Actually, for some products, fees have recently been reduced.

DSCs

It is most important to dedicate a section to DSCs (Deferred Sales Charges). As mentioned before, IG does have lower redemption rates, even vs. Mackenzie. Here the 12-month trailing redemption rate for long-term funds

So how does crappy IG keep all these clients? Certainly not because of the “comprehensive approach to financial planning, provided by our Consultants.”

The Canadian mutual fund industry has its unique way of charging fees. This page provides a good overview of practices:

http://wheredoesallmymoneygo.com/how-mutual-fund-sales-are-compensated-in-canada/

I will talk about how it applies to IG: first of all, IG is the second largest mutual fund manager inCanada. So when it is said that 20% of Canadian funds have DSCs, IG is the #1 culprit and IGM as a whole probably accounts for most of that 20%.

The DSC is a fee to redeem your investment. Here’s the schedule:

Now, one may argue that this is the deal that investors accepted and therefore they obviously accept to live with it. But that’s where it gets tricky: combine DSCs with horrible company culture and you get stories of angry clients with DSCs they never knew about. Here’s an explanation from a former consultant:

Probably the biggest dirty secret of IG is unless they invest you in funds with DSCs, they basically don’t get paid.  Yes, the no load funds do pay a small (and I do mean small, it’s 25 bps) commission on the front end, but the planners at IG have so much incentive to lock you in it’s no small wonder that every IG statement I’ve come across since I left has been invested in their A or C series (the ones with DSCs).   They will use the excuse “Well the sales charges prevent you from taking the money out earlier”.  Please, why would any rational planner who has his or her client’s interests at heart place them in a situation where they had to pay up to 7% just to access their own money?   Note: doing a reallocation of funds resets the DSC schedule.

And a former client:

Reinitialization of DSC schedule – either once your DSC fee schedule has run out, or just before it runs out, your IG ‘consultant’ will recommend a “much better performing” mutual fund and will sell your current fund and buy into the new one…and you are once again on the hook for another 7 years.

So how does that play into the thesis?

-          Superficially one would argue that the AUM is worth more because it stays on longer but:

-          You can’t fool all of the people all of the time and Canadians are turning their backs on IG. As per the AUM trends shown above + anecdotal evidence, AUM growth is way below average. There are a lot of angry people waiting for their 7 years to expire. So whatever IG gains in terms of asset life, it loses (or worse) in terms of total assets and therefore intrinsic value.

-          Declines in AUM hurt. During 2012-2013, the situation at IG was reported to me as being quite bad. The office where I know more consultants than any other (actually, that one is one of the best performing offices inCanada- extremely aggressive practices) has had an outflow of assets and consultants. Consultants with a good head on their shoulder have followed one another into respectable firms and bad consultants changed careers. It is quite gloomy, while the rest of the financial world has enjoyed a bull market!

-          During the next bear market this will get even worse and clients will get even angrier at IG

-          Given that Canadians have consumer debt, during the next recession, they will need their mutual fund money that earns no yield and declines in price while costing them lots in fees.

-          If AUM is flat now, it is only logical that IG will move into a secular decline in AUM. The economics will be ugly due to operational leverage and morale will be even lower.

Canadian economy and stock market

The Canadian economy and its equity market play clearly a big role in this thesis as asset management stocks are leveraged to financial markets.Canada’s macro prospects have been discussed in at least one idea before (I believe BMO) so I will only summarize:

-         Canada’s economy is highly concentrated in finance and commodities and thus dependant on emerging markets which have arguably seen their highs for this cycle and are slowing down markedly.

-          Over the past decade housing has played a large role in the economy. There is a housing bubble with price/income and price/rent ratios about equal or slightly below those in theU.S.in 2005. After decades of growing proportionately to income, HPA has simply disconnected. The bubble is tired. You see a lot of developers advertising condos for their beauty in one last desperate attempt before they proceed with the obligatory 20-30% discounts. Billboards advertise no-money-down condos, people talk about condos with great admiration & emotion and assume that prices can’t go down more than 10% just as interest rates can never gap up. New supply is being built everywhere, including an increasing amount of condo conversions. There is a high presence of Asian investors in all major markets. Basically a textbook bubble.

-          Personal debt inCanadais a new phenomenon and recently stood at 162% of income. Much of the growth is of course mortgages and HELOCs. Unlike in theU.S., lenders have recourse and therefore Canadians have even more incentive to redeem mutual funds in order to make their mortgage payments.

Asset management dynamics

Another quick and mostly unnecessary observation for readers: asset managers are leveraged to the market on many levels. In a bear market: (i) AUM declines due to negative investment returns (ii) AUM declines due to client redemptions (iii) the operational leverage means that profits decline even more than revenues and (iv) the sector gets lower multiples.

And for IGM there’s a fifth factor that should take hold in the next downturn: consultants and clients throwing in the towel in a bigger way than they already are, leading to a potential spiral of secularly declining AUM.

Valuation

IGM trades at 11% of AUM, as does its peer CI financial. On a relative basis we therefore already have a good pair trade. On an absolute basis a normal valuation for a standard asset manager could be around 2-3% and even 1% if it is large and crappy. A good shop with alternative investments can get 6-8%. But 11% is a bit too much.

The big opportunity here is threefold:

1)      When the market realizes AUM is going into secular decline, this stock no longer gets priced on perpetual growth

2)      In a bear market these stocks always do horrible

3)      The synergy between (1) and (2)

The sequence according to (1) is that the initial AUM loss leading to declining revenue, margin compression and a spiral of bad news, and then multiple compression when the market doesn’t want to hear anything anymore. Normally that sequence could take some time to solidly play out as we’ve seen. The good thing in the catalyst in (2). A bear market would take a stock like this lower earlier. But the really juicy thing is (3). A bear market would not only lower the stock price lower, but the intrinsic value as well. It is these large market cycles that get clients and consultants really frustrated.

The market is giving this thing a P/S of 5.2 which implies 30% margins at a P/E of 15. Once things go south we could easily see 10x or lower, on lower margins.

Consensus is that IG is capable of charging some of the most ridiculous fees in the western world forever, on a growing pile of AUM, even though it has already begun reducing these fees and even though AUM is not really growing. Consensus is wrong.