Federated Hermes Inc (FHI) 2009 Q3 法說會逐字稿

Greetings, and welcome to the Federated Investors Q3 earnings call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions)

It is now my pleasure to introduce your host, Mr. Raymond J. Hanley, President for Federated Investors Management Company. Thank you, Mr. Hanley, you may begin.

Good morning, and welcome. Today we plan some brief remarks before opening up for your questions. Leading today's call will be Chris Donahue, Federated's CEO; Tom Donahue, Chief Financial Officer; Dennis McAuley, Laurie Hensler, and Stacy Friday are here from the Corporate Finance Group, and Debbie Cunningham, our Chief Investment Officer for money markets will join us for questions as well.

Let me start by saying that certain statements in the presentation including those related to investment and financial performance and asset levels will constitute forward-looking statements, which involve known and unknown risks that may cause the actual results to be materially different from future results implied by such forward-looking statements.

For a discussion of risk factors, please see our Federated's SEC filings. And no assurance can be given as to future results. Neither Federated nor any other person assumes responsibility for the accuracy and completeness of such statements in the future. And with that, I will turn it over to Chris.

Thank you, Ray, and good morning. I will begin by reviewing Federated's recent business performance before turning the call over to Tom to discuss our financials.

Starting with the cash management business, money market assets decreased by $28 billion or 8% from the prior quarter with most of the decrease coming from money market funds. However, money market assets at quarter end were $30 billion higher compared with the third quarter of 2008. We saw elevated redemptions in September, in particular at mid-month around the September 15 corporate tax payment date.

As in Q2, more favorable market conditions for stocks and bonds likely led to lower money fund balances at Federated and across the industry. Federated also has benefited from better market conditions as evidenced by our solid sales of bond and equity funds and asset and revenue growth in these areas during the third quarter.

Low interest rates continue to impact yields and fee waivers for money funds. Tom will provide some more information during his remarks. As we look at money market asset levels over the last several quarters, we have a different take than those lamenting the recent outflows.

To us it is clear that money funds are a vital part of the financial system and offer efficient cash management services to investors through all types of market conditions. Changes in volumes are a natural part of how this business operates. During the past two years, money funds generally provided an attractive haven during the worst of the market swings and credit crisis issues.

Inflow levels were unprecedented and it's not unexpected that some of these assets would move around as market conditions improve. Federated has operated successfully through other high and low cycles over decades of cash management experience.

We tend to look beyond event-driven peak and trough asset levels to focus on the strength of our underlying cash management service business. Federated retains its strong core client base, who depend on our money market products as an essential component of cash management services. We expect this core business to continue to grow over time with higher highs and higher lows during particular cycles as we have experienced over the last 30-plus years in this business.

As the cycle turns, we are in close contact with clients to help them as they navigate changing market conditions. Our sales personnel are emphasizing our full product line so that as customers consider asset reallocations, we are responding to the full suite of products.

Our high quality fixed-income strategies ranging from short-duration bonds to total return international high yield are winning business in both funds and separate accounts. Within equities, we see traction in the alternative and dividend income strategies reflecting a defensive stance even as investors begin to rethink their allocations. We have a variety of products in multiple areas that are well positioned for higher sales.

Our efforts are paying off as evidenced by share gaining bond and equity fund sales. For bond funds, our share of industry gross sales increased from under 0.5% in 2007 and 2008 to just under 1.5% for the fist eight months of 2009. Our equity gross fund sales share has also increased in 2009 compared to 2007 and 2008.

Based on Strategic Insight data, Federated ranks 11th in the industry for year-to-date combined fixed income and equity fund net sales and has produced an 18% annualized organic growth rate for net flows in fixed income and equity funds in 2009. Thus, we welcome improved market conditions for bonds and equities and believe that we are well positioned to capture flows as investors consider reallocations from a variety of sources.

Looking more specifically at equities, assets increased by about $3 billion or 11% during the third quarter. Equity fund flows were positive and increased from the prior quarter. Alternative strategy mutual funds were responsible for most of the net positive flows with good results from both the Prudent Bear and Market Opportunity funds.

This strategic value dividend oriented fund continues to show solid flows as does the Kaufmann Small Cap fund. Our equity mutual fund flows continue to be positive for the first couple of weeks here in October, although as usual, we caution about drawing conclusions from limited time data.

Within equity separate accounts, outflows were largely due to net redemptions in our SMA products. Bond fund sales, again, dominated the industry in the third quarter. Reflecting the balance and diversity of our Company, Federated's fixed income products again showed very strong sales results, gaining share against strong industry flows as I mentioned. Gross bond fund sales increased 4% to $4.8 billion from the prior quarter's elevated level.

Net bond fund sales were strong, at $1.8 billion for the quarter and reached a little over $5.5 billion on a year-to-date basis. About half of our recent bond fund sales and redemptions have been in ultrashort products. Flows in these products tend to have higher velocity as certain investors use them as long cash products, especially in low-interest rate environments.

We are working with clients who are using these products to expand their business into other areas and to position other products for potential reallocations that are made by these clients. We continue to have positive net flows in most bond fund categories, including corporates, high yield, munis and multi-sector. Our flagship Total Return bond fund gross and net sales continue to increase.

We saw solid net inflows in fixed income institutional assets during the quarter. In the third quarter, we won a handful of mandates, some of which went into mutual funds rather than separate accounts. We have about $150 million yet to be funded going into the fourth quarter.

Turning to investment performance and looking at the quarter end Lipper rankings for Federated's equity funds, 23% of rated assets were in the first or second quartile over the last year, 73% over three years, 86% over five years, and 78% over 10 years. For bond fund assets, the comparable first and second quartile percentages are 32% for one year, 67% for thee years, 73% for five years and 79% for 10 years.

The decrease in one-year equity assets in the top quartiles was largely due to the defensive positioning of certain funds relative to the recent large market upswing. Within the fixed income area, the decrease in one-year Lipper rankings at 9/30 reflects in large part the success we had in 2008 with the high quality of our products.

Returns in 2009 so far have favored lower quality products. Our thee, five, and 10-year records are strong and we are above benchmarks in most of our taxable fixed income strategies on a one, three, and five-year basis. As of October 21, our managed assets were approximately $390 billion, including $315 billion in money market, $29 billion in equities and $46 billion in fixed income, which includes our liquidation portfolios.

Money market mutual fund assets stand at about $286 billion. So far in October, our money fund assets have ranged between $283 billion and $291 billion, and the average is about $287 billion. Regarding distribution, our sales force produced outstanding results again in the third quarter. Building from strong growth in 2008, and the first half of 2009, the third quarter saw another step up in the pace of our fund sales results as we crossed over the $2 billion in average monthly sales of equity and bond funds.

The third quarter pace is nearly double the monthly average achieved in 2008. Regarding acquisitions, we are close to achieving full integration of the Prudent Bear and Clover Capital acquisitions from December of 2008. We are focused on expanding distribution for these products and have had success in bringing these products to new distribution opportunities.

At this point, we are not looking for acquisitions targeted to specific investment expertise, though this type of deal always remains a responsibility. We continue to evaluate multiple acquisition opportunities to add further assets, including money market consolidation deals.

In addition, we will consider acquisitions or partnerships outside of the United States as part of a developing strategy to expand global distribution. As always, we cannot predict the probability or timing of any potential or particular deals. Tom? Thank you, Chris. Federated's revenue decreased about 4% in Q3 from the prior quarter and from Q3 2008. Compared to the prior quarter, lower revenues from money market funds were partially offset by higher revenues from equities and fixed income.

The Q3 revenue impact of money funds waivers to keep yields positive or zero was $36.5 million, partially offset by $27.9 million in related lower marketing and distribution expenses. The impact to operating income from these waivers was $8.6 million, compared to $5.6 million in Q2. Based on current market conditions and current assets, we expect the impact to Q4 and Q1 2010 operating income to be approximately $14 million to $15.5 million.

The increase in the run rate is due mainly to further decline in yields that have occurred over the last couple of months. In terms of sensitivity, we estimate that a 10-basis-point increase in yields would reduce the waiver impact by about one-third while a 25-basis-point increase in yield would reduce the impact by about two-thirds.

I want to emphasize that there remains a wide spectrum of potential outcomes given the multiple variables involved including yield levels available in the market, changes in assets within the fund, actions by the Fed and Treasury, changes in expenses of the fund, mix of customer assets, and our willingness to continue the waivers.

Turning to operating expenses, we remain diligent and focused on proper expense management. Operating expenses were down substantially from the prior quarter and from Q3 2008. The drop in Q3 2008 occurred despite the impact of two acquisitions completed in Q4 2008. On the balance sheet, cash and short-term investments were $87 million at the end of the quarter and recourse debt was $130 million.

We repurchased about 471,000 shares in the quarter. We continue to generate strong free cash flow and expect we will continue to use cash and our revolver to fund acquisitions, dividends, share repurchases, capital expenditures and debt repayment, We would now like to open the call up for questions.

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. (Operator Instructions) Our first question is coming from Michael Kim with Sandler O'Neill. Please state your question.

Hey, guys, good morning.

Good morning.

Just first, in terms of the money market fund, it sounds like some retail investors are increasingly turning to bank deposits to maybe earn some higher yields. I know it's difficult for you guys to see exactly where some of the money is going, but do you get a sense that you're losing market share there or are you not really impacted all that much just given your client base?

Given the client base, as you say, Mike it's difficult to see that exactly. I suspect there is some modest movement because it is true that retail investors are going from some money market funds into MMDAs with higher yields.

But the institutional base of our business is a cash management service that really isn't as much influenced by that. We just don't see it the way that others do. Not that it's not true.

Okay. Then maybe to transition to kind of the institutional investor base, it seems like a lot of investors have yet to kind of make any big moves in terms of rebalancing their portfolios. Where do you think we are in that process? Is it possible that we see maybe another step up in redemptions across the industry when, in fact, that does happen?

It's very difficult to predict. It's also very difficult to predict how that will be influenced by moves by the Fed whenever that would occur. So we would just be more or less speculating on our view of where the market is going to go. We would expect that you would continue to see redemptions, net redemptions in these money funds at this point, but to a modest extent.

And that's why I mentioned in my remarks that even though the money fund assets were down by $28 billion during the quarter, we're still up over $30 billion from the prior year. And it's just to try and give a sense of balance and long-term movement that, yes, there is movements but the long-term efficacy of the cash management business remains intact. Perhaps Debbie has a futuristic view of this different than what I've said.

I think the only thing I'd add, Chris, is obviously it's a cyclical business. When rates are declining and stable for the most part we're gathering assets in the money fund industry. On the other side of the equation, when interest rates do start to go back up again, the likelihood of decrease in assets is what's been seen in past history.

Okay then. In terms of capital management, it seems like you kind of continue to preserve liquidity to be conservative, but it looks like the buybacks did ramp up a bit this quarter.

So just assuming a deal doesn't materialize, should we expect you guys to get more aggressive on repurchases at some point?

Our history has been we use cash and not held it on the balance sheet. When we have deals our history has been we've used it on deals. When we haven't had deals, our history's been we've purchased shares back or paid dividends. So I think you can look to our past to predict the future. Even though you are not allowed to do that in a mutual fund.

Okay. Fair enough. Thanks for taking all my questions.

Our next question is coming from Keith Walsh with Citigroup. Please state your question.

Good morning, everyone, thanks. Two questions. First, on the deals out in the industry. You talked a little more about this quarter than you did last, but just on the money market side, with the low rates, outflows and regulatory overhang, for some of the marginal players do you think that's going to really accelerate maybe their exit from this business? Is that why you are talking about this issue a little bit more?

I actually have a statistic that I saw that was presented by Brian Reid at the ICI. He's their chief economist just Monday of this week. And effectively what he was showing was a pie chart that showed the top players in the industry, one through five, six through 10, 11 through 15, so in five-firm increments and their percentage of market share. He showed it at year end 2000, and then he showed it as of 6/30/09.

At year end 2000, the top 10 players in the money fund industry, according to the ICI's statistics had about a third of the market. So about 33% market share. At the end of June 30, it was nearly 75% by those same top 10. So I think we've already seen a lot of that consolidation. But the potential for more still exists.

Okay, that's great. Thank you. Just on the fixed income side, I mean, you talked about this earlier. The flows are strong for everybody, but you guys seem to be gaining a little more traction with the market share gains. What's really the driver here besides performance? Are there changes to the way that you're marketing this product? If you could just give us a little color around that? Thanks.

One of the things is the -- it's surfacing in the marketplace the beauty of a long-term team. There are 85 fixed-income professionals divided up by a third portfolio managers, a third traders, and a third analysts. The PM's, for example, have 21 years of experience and about 17 years of those years are with Federated.

So this team has a long time together which means that the customers know who these people are, how they think, and how they act because we stay connected with the clients.

So this is the integration of Federated with the sales and the performance in the face of the customers. So now with all of this work having been done, when the worm turns and points towards fixed income, given the good performance and then the connection with the people and the understanding that this team has been here for so long, it is a true additional strength. Keith, I just add a thought to that that clients appreciate our performance over the full cycle. They've seen how we've performed during the credit crisis, how our funds were positioned, and if you look at some of our strategies, our total return strategy, in particular, you can see how that played out. And so the performance in that period certainly helped us as does our general risk profile within fixed income. We're able to demonstrate substantial and solid performance over the full cycle at a lower level of risk than some of the other players.

Thanks a lot.

Our next question is coming from Marc Irizarry with Goldman Sachs.

Hello, great,thanks. A question on the fee waiver guidance. For the fourth quarter, I think you said a $14 million to $15.5 million, and that was net. Can you give us the gross part of it?

Like what's kind of the margin? I guess the question associated with that is that the margin on the fee waiver it appears that the channels may be taking a little more of the fee waiver on their end than we would have thought. So maybe you can help us think through that?

Well, Marc, when you think about the mix, remember that we have products that are priced in a lot of different ways. So across that spectrum, the percentage that goes to effectively to the intermediary varies. So you've seen that kind of step up a bit, and that's really a function of where the assets are, what particular funds and how that moves around.

I think you could, in terms of the first part of your question on the gross, you could take the -- if we're at 8.6 for the third quarter, and going up to a range of $14 million to $15 million, you could apply that kind of step up to both the revenue and the related expenses and you'd be in the ballpark of where we think these waivers would be, again, emphasizing based on where the yields are now and where the assets are now.

So the dollar cost absorbed by the channel and obviously it's mix dependent then?

Right.

And you're not anticipating much of a change in that mix?

No. It could happen, but it's hard for us to predict that kind of a change.

Okay.

Marc, this is Tom. We're just trying to put some numbers out there for people to have something to circle around. It's not really our guidance. If market conditions and rates are right where they and assets stay right where they are and then a while bunch of other things and none of those are going to happen. But we're trying to give you something to grab onto, despite the many variables.

Very much appreciated. Speaking of things that could happen, do you have an outlook on rates that you guys would be willing to share with us? And then also you said the 25-basis-point change in the yield. What yield are you referring to specifically?

Let me start with a couple things. Number one, one of the biggest impacts in the third quarter that was not necessarily apparent in either the first or the second quarter despite the fact that the Fed fund target range of 0 to .25 has been identical was the fact that repo and the Fed funds, the actual Fed funds rate itself, traded much, much lower within that 0 to .25 range, somewhere down to 7, 8, 9 basis points to the lower teens versus what had been more like 20 to 25 basis points in the first two quarters and even into the first part of the third quarter.

Why did that occur? That occurred because a lot of the collateral in the system had been taken out by the Fed. If you look at the Fed's balance sheet there's a lot of discussion about the $1.2 trillion in Treasuries, government agencies and mortgage backs that sit on that balance sheet right now that the market would love to see come back into play from a collateral perspective.

Obviously, the Fed has said they are contemplating doing reverse repo. If, in fact, that were the case or when that becomes the case that in and of itself without anything happening from a true rate change perspective will allow that target range to go back up and the Fed fund's effective rate to be much more near where it was at the beginning of the year in the 20 to 25-point basis point range.

That's something that if we do $100 billion worth of repo at any single day on a 10-basis-point level, and that, in fact, then changes to a 20-basis-point level for that same $100 billion, obviously there's real money that's differentiated there. So that's the first thing to think about. The second thing has to do with ultimately our outlook for the target rate itself and what that means in the context of the yield curve.

We've actually seen a few things happen over the last several weeks that give us a little bit of a positive implication that maybe the beginnings of the process are underway with Australia raising rates, with a little bit of the Fed speak, tone changing to some degree. We've actually seen a steepening of the money market yield curve and at least in the nine to 12-month sector of the curve, LIBOR rates backing up just a tad bit which hasn't been the case really since the beginning part of 2009.

So that's effective in the context of how we overall are managing the fund. Ultimately, though, if you're looking for when we think the Fed will actually raise rates from that current 0 to .25 range, probably the only thing we're in agreement about at this point is they won't lower it anymore. In the context of raising it, we're still in the second quarter of 2010 from a most likely scenario standpoint.

Marc, on the 25 basis points that's simply taking the reinvestment rates that have been in place and bumping them up by 10 or 25 basis points to get kind of a mass answer on waivers.

Okay, great. Thanks. That's helpful.

Our next question is coming from Robert Lee with KBW.

Thanks. Good morning, guys.

Good morning, Rob.

First, I guess, quick P&L geography kind of question. The liquidating portfolios. You had that big block of assets come on. Where's the revenue from that going to flow through? Is that going to flow through advisory fees or is that flowing through other income or someplace? Is any sense you could give us some kind of a -- fee raise kind of similar to the Florida mandate you got and the money funds were a little higher?

Hey, Rob, it's Ray. The revenue will flow through advisory fees. We're providing advisory services there. That's what we've done with other mandates in that area.

And, yes, I think you can generally infer that fee rates, we can't comment on specific fee rates, but fee rates on this type of mandate are lower than different types of mandates. Beyond that it's tough for to us quantify it.

Okay. And maybe just one other quick question, I mean, I understand the redemption rate and fixed income being up because of the nature of the ultrashort product, but it looks like the redemption rates and the equity book continue to run at reasonably high rates and even picked up a bit.

I'm just curious if there was, maybe talk a little bit about what about book of business kind of continues to drive kind of the higher the industry average redemption rate?

Rob, there's a couple things there. The products that we have with an alternative bent like Prudent Bear that would not have been in our numbers before. While it had solid positive flows in the quarter, it would have related redemptions as well. So if you're comparing back more than a couple quarters ago, you would not have had either the sales or the redemption in that number.

Market Opportunity's another product with with an alternative bent that, where we see more swings in both inflows and outflows. Beyond those two, I think that's the redemptions, the gross levels are down from where they were a couple of quarters ago, up a little bit from last quarter. I don't know that there's anything else unusual that we'd point to.

Okay. That was it. Thanks, guys.

Your next question is coming from Craig Siegenthaler with Credit Suisse.

Thanks, and good morning.

Good morning.

Just a follow-up here on Marc's question. Just to get it kind of clear, I think, on the fee waiver. Fee waivers are roughly, I think, about 17 and change. Last quarter went up to about $37 million. This quarter, although the earnings impact went down from I think about $6 million last quarter to about $3 million this quarter.

The first question, is that math roughly right? And also, you talked about why that margin, the expense offset increase. It looks like it's about 90% of the fee waivers here. So far this far in the fourth quarter, where are we in terms of the level of kind of the revenue fee waiver you expect and the expense margin of that?

Craig, the math is not right. The fee waivers were affected revenue by $36.5 million and affected the related marketing and distribution expense by about $27.9 million. So the operating income impact from the waivers was $8.6 million.

So it would have been plus $3 million from June, but still $8.6 million. And in terms of looking at it going forward, if, I'd just go back to what I said. If to get to something like a $14 million to $15 million number, that implies, on operating income, that implies a certain rate of increase from $8.6 million.

If you apply that rate to both the revenue and the related expense, you'll be in the ballpark, at least as close as, again, given all the things that can vary. That would put you pretty close.

And, Ray, on that $36.6 million, do you think that's a good run rate here? Do you expect that to come back a little bit? Do you think it could go up a little bit? Or no real color on that now because that's so many moving pieces?

No, we think it's going to go up based on current assets and market conditions. But so will the marketing and distribution offset. That's where we're telling you to do essentially bump both of those up in the same neighborhood that implied by the guidance we're giving you on the operating income impact. I can -- we can walk through it offline if --

Perfect. Thanks a lot, guys.

Okay.

Our next question is coming from Cynthia Mayer with Banc of America.

Hi, good morning.

Good morning, Cynthia.

In terms of cost control it seems like a number of items declined in the quarter, obviously, comp and travel and promotion. I'm just wondering how much further can cost control go? And since sometimes you guys true up in the fourth quarter, do you have any thoughts on 4Q comp?

Okay, Cynthia. We actually think we've done an excellent job of trying to contain costs through the difficult economic cycle, and are looking to try to maintain things. We, of course, continue to invest in technology and in the investment area and a few other things that we have to do.

And you actually notice, there are a couple line items up, even though the majority of them are down. In terms of comp in the future, I have to sign a document that says this is what we expect the incentive compensation to be each quarter. And I signed it this quarter, and it's where we think it will be.

What will happen in the rest of the fourth quarter? We hope that it goes up because that will have meant that sales went up and performance went up and overall Company performance went up.

Okay. And then just a question on the Kaufmann fund, which I know is one of your higher fee funds. It looks like it's got five stars now but still has outflows. Do you guys see this just as a function of where flows are going in the industry and do you see any movement in that? Are you getting ant feedback from sales on potential for that fund?

The potential for that fund over the long haul is to get back to, I think, where we had it before. Remember that was a $10 billion fund. Remember, we he purchased it and it was a little over three. It had been six. It's now back about at that level.

So the long-term potential is there. The sales remain strong even in the face of basically a net redemption profile that you've pointed out. The performance over the long haul is still outstanding and the growth aspects of that fund and its long-term performance, we think, are still going to keep it in the ballpark. Its recent performance has slipped a little, but it hasn't dented that long-term record.

And, Cynthia, I think if you remember when we joined forces with Kaufmann it was a single product enterprise. We've since added both a large cap and a small cap fund. If you look at those collectively, they have net positive flows. So some of what you're seeing are people going into, in particular, the small cap Kaufmann fund but also the large cap is garnering positive flows.

Great. Thank you.

Our next question is coming from Ken Worthington with JPMorgan.

Hi. Good morning.

Good morning, Ken.

In the last cycle, and I guess this cycle, Federated is doing a very good job of winning sales into the short-term bond funds. Rates got low last time. Investors are looking for yield and, again, same thing is happening today. But maybe it was less successful migrating from the fixed income to the equity funds when that shift took place.

And I think then the bond funds got killed as that transition happened into equities for the industry. Assuming that's the next step for the industry, this migration from fixed income back to equities, how will things be or maybe why will things be different this time for Federated? Performance is better.

Are there other things that you're doing to maybe capture more of those sales as they transition into equities in a maybe bigger way this cycle?

Well, don't forget that in the fourth quarter of 2008, we concluded two, the purchase of two equity deals, Prudent Bear, which is not exactly online with the spirit of the question you're asking, but also Clover. And one of the reasons why our numbers limped a little in the past was that our ability to play ball on the value equity side was somewhat dampened.

Now with this Clover purchase, we think we are in excellent position across that group and others to be able to play ball. And their performance has been outstanding, and so we think that is a primary ingredient of why we think we will do better this time.

Next point would be that in the time frame of the late 1990s when we had product that was highly rated, we were able to gain market share on sales, net sales and assets. And so this sales force in this effort has proven its ability that if it has those products then it will be able to accomplish that.

That's why we mentioned that those are the kinds of things we're accomplishing right now, although it's on a slightly dampened basis. So we would look forward that if the market changes and if people do go for more risk assets that we would be ready, willing and able and participate in it the way you've described.

And one more comment to Chris' comment. We are seeing the equity funds at a slight positive level right now, and the industry is not. So there's an early indicator that what he's saying is going to happen as we expect.

Great point. Thank you very much.

Our next question is coming from Roger Freeman with Barclays Capital. Please state your question.

Hi, good morning. I guess maybe to follow on Ken's question. How proactive are you or can you be given your more retail oriented customer base in the money market business to get out ahead of this and propose alternative longer data investments, equity products as opposed to just sort of letting those flows out the door?

I'll give you two responses to that. The first is that the Ultrashort is a giant linking verb in this whole connection. Because people are moving out the curve, it gives them a little more yield and yet sets them up for our sales force to talk about alternative product.

However, don't forget that our principal client is 5,300 institutions that are offering asset allocation and investment advice services to their underlying clients. And so for us, it is repeating the solid stories on a constant basis.

There's no magic bullet. There's no silver catalyst. It isn't like that. It is the constant pattern of A blocking B that gets you to where you want to be in this business.

Okay. That's helpful, thanks. And now, I guess a question on compensation. Just the -- I know you don't pay out this way, but the Contra revenue ratio increased sequentially. Presumably that's because of better performance in the credit and equity funds. How much of compensation for those folks is tied to performance specifically?

The investment incentive comp is heavily weighted toward performance measured against peers and to a lesser extent benchmarks. So it varies across groups, but something in the 70% to 80% range is a good estimate of how much of the incentive comp is tied to investment performance.

Okay. So that will get reset quarterly based on --

Well, the way -- this is a constant exercise, and our performance has been pretty solid over multiple quarters. So I would not attribute the change in the ratio that you mentioned to any particular change in that particular set of underlying programs. As you point out, it's not really something we manage to. It's really a number that falls out when we add up all of the plans and take it back to revenue.

Yes. I guess it seems a couple others as well. I'm just wondering as performance improves and particularly on a relative basis and compensation comes up to reflect that, but yet maybe the flows that would ultimately come from that improved performance haven't really started to come through yet. Do you see any sort of negative degradation in margin, is there sort of a timing issue to think about there?

Roger, this is Tom. First of all, the bonus programs have components of long-term performance. So to move it takes a real movement to move it.

Would we have a situation where our performance is great and the sales force hasn't started to sell the product yet and that's going to hurt our margins? We haven't really faced that because of the dynamic and basically diversified business model that we've had is it hasn't come to be a problem here.

Got it. Okay. And just a somewhat sort of related question, how do you think about the marginal profitability or profit impact of a dollar coming out of, say, money markets versus a dollar coming going into equities or fixed income taking into account the commission's paid to bring those dollars into these other asset classes and then the scale loss on the money market?

Sure. We don't really think about it that way. Although, to answer your question or I think the spirit of your question in a different way, you see our margin went up.

What happened, we lost money market assets and we gained equity and fixed income assets and our margin went up. So --

Your operating margin?

Sure.

Right. But I mean part of that is your cost reduction efforts on the fixed side. I guess I'm just interested more from a variable standpoint.

The thing you could look at, Roger, really the revenue replacement rates, revenue comparison rates. We don't measure profitability at the asset class level.

We don't have the data to do that, but if you take funds and look at revenue, you'd have maybe a three to one, two to three to one advisory fee rate between the average for bond funds and the average for money funds.

If you go to equities, depending on the product, you're more in the six or seven range. So growth, it is self-evident that growth in the equities and bond funds, you don't need dollar-for-dollar growth to offset decreases on the money fund.

Okay. That's very helpful. Lastly, any update on sort of capital requirements? What do you think the chances are of a liquidity bank versus individual capital requirements?

As we have said before, we don't think nor would we predict that there will be a capital requirement or reserve requirement placed on the money funds or on the investment advisors. The efforts on the liquidity bank we're just not in a position to comment on other than to say that we're aware that people are working on it.

Okay. Thanks.

Our next question is coming from William Katz with Buckingham Research.

Thank you. Just a couple questions. Debbie, I'm sort of curious, maybe you could sort of weigh in on this one. In your comments about sort of the longer end of the one-year curve moving more favorably, yet you still took the fee waiver guidance up a little bit. I'm just sort of curious as whether dynamics might be going on. Is it mix here or anything else I need to think through?

From our perspective it's more the contemplation that as the back end starts to steepen out a little bit and there is a little more relative value in that sector, generally speaking, we're contemplating getting closer to when actual rate movements occur. And the 0 to .25 becomes 50 or 75 or 100 in which case generally our response to those potential changes is to reduce our weighted average maturities within those products.

So even though the longer end is getting more attractive, we're, for the most part, taking less of that and more of a variable rate type product just to be able to reflect more quickly what we would anticipate as rising rates sooner rather than later in those instances.

Bill, really, what you're seeing is just the math of the existing portfolios that even as the process unwinds as Debbie talks about, the assets are in the funds now. They're at lower yields than they were before, and so that's, you're going to get more of that in Q4 than you got in Q3. What happens in 2010 is very much an open question.

Okay. Second question and then one after that. A number of your peers have reported to date have sort of signaled that investment spending into 2010 is going to accelerate after a couple years of under investment given sort of what's happening in the assets. I know you've been relatively protected given the defensibility of the money market business. That being said, I was sort of wondering if you could talk a little bit about your investment needs as you look out to 2010?

First off, I don't think we've under invested at all. I don't think we've had the benefit through 2007 and 2008 to maintain our staff. And you get people that we needed to, and you know, also do it while we're managing the expenses properly.

In terms of comp going up, it's our comp programs are what they are, and we expect them to go up because we expect the performance to improve.

Okay. So I shouldn't use the word under invested, just less of a cut relative to your peers, I guess. Third question I wondered if you could weigh in a little bit. Yesterday, I think you were on CNBC and then again this morning you sort of said it seems like a little more receptive to a deal outside the United States.

I'm just sort of curious if you could maybe expand on that a little bit, what type of capability you're looking for. Is it product distribution and secondarily, I was sort of wondering if you could talk about how you might finance such a transaction?

On the finance, it depends on what the deal would be, of course. So it's really tough to figure out where that would be when we're only opening the door to the concept. So getting way down to the financing of it, it's just not going to be a fruitful discussion. We believe that we have the ability and the wherewithal to finance any deal that we think we would do. And we're disciplined enough in doing the deals that we have a lot of confidence in that.

In terms of where we go and what we would do, I'll give you more of a method than a direct answer. Gordy Saracino, who is the CEO of one of our acquisition candidates, has been putting together with a team from Federated some ideas as where we might go and what we might do. And I suspect it will be a combination of some organic growth. We do have good business in Germany, good partners there. We've had efforts in London as well.

But we're trying to take a brainstorm at looking across the globe in order to enhance some distribution internationally. So I'm not at this point able to tell you even which jurisdictions or things we would, areas we'd be looking at. In terms of how, though, your question asks some of that.

We would tend not to do that, oh, here is tons of money. Let's put it in and get our name up and go direct. That would not be what you would expect. What you would expect would be a partnership kind of a thing, not unlike our LVM deal, where in that deal we're working on their family of funds.

They've got some distribution. We're managing some money for them. That kind of arrangement is more attuned to the culture that we have here that we think could work for the long haul. So that is the kind of thing that we would be looking at.

Okay, that's helpful. Thank you very much.

Our next question is coming from Mike Carrier with Deutsche Bank.

Thanks, guys. Just a quick question on the mix shift. Historically, when the money markets start to bleed out and then the equity fixed income products make up a bigger portion of the pie, just given the fee rate differential you get the positive fee rate shift.

In the current environment that's being offset by the fee waivers. But when you think about where interest rates are and, I guess, the duration of the money market products, you gave the guidance for the fourth quarter one quarter on the net fee waivers. When you start looking like beyond that, I guess if rates stay unchanged, then should the full impact -- should we kind of be at the full impact so if you continue to see more of a mix shift you get some of the benefit on the fee rate?

Mike, my comments were for $14 million to $15.5 million for the fourth quarter and for the first quarter. And if you start going out beyond that and say the rates aren't going to change, I don't see much difference.

Okay. So that's what I was getting at, meaning if most of the portfolio has turned over and if the rates remain unchanged, then there shouldn't be any significant increases?

Right.

Okay. All right. And the other one is just on the expenses, obviously they came down a lot. We can back out the shared fee waiver from the distributors. But anything else on any of those lines, I understand the synergies with the acquisitions. But anything else that was unusually low just so when we look forward we're not underestimating some of the costs?

Well, we did a pretty, even though they are not big numbers, a pretty significant thing in travel and related and in advertising and promotion. Their not big dollars. And you know, could those bump back up a little bit in the fourth quarter. I don't think there's any big change there, though.

Okay, all right. Thanks a lot, guys.

Our next question is a follow-up from Mark Irizarry from Goldman Sachs.

Oh, great. Thanks. I think historically you gave money market fund AUM by type, by breaking it down by government, by prime assets. Can you just give us an update of where you are in AUM by type of fund and then also by channel? And then I just have a real quick follow-up.

It was about $42 billion in Treasury, $102 billion in government agency, $104 billion in prime and $40 billion in munis. And if you want to know how they moved around during the third quarter, the Treasury funds were down about 10. The agencies were down about 12. Prime was down about 4 and munis were up about 2.

Okay, then just in terms of the separate accounts, the money market AUM that you break out in separate accounts, is that predominantly institutional and then it looks like the assets there declined more than the mutual funds. Does that, therefore, indicate that you're seeing an acceleration in outflows from institutions?

No, Marc, I wouldn't make that jump. That number for us has always been essentially a couple of large state pool mandates where we manage money in Texas and in Florida, and there's been a regular pattern of seasonality there related to the underlying tax collection rates such that we've typically seen those assets go up at the end of the year and in the first quarter when the states are collecting taxes.

Then that gets drawn down a bit over Q2 and Q3. So that's regular and specific state tax related seasonality and not a broader institutional comment.

Okay. Great. Thanks.

Sure.

And our last question is a follow-up from Cynthia Mayer with Banc of America.

Hi, thanks. Yes, just a couple quick follow-ups. I think in normal years, and I know this is not a normal year, but I think in normal years, 4Q is typically a pretty good quarter for money market inflows from corporate clients.

I'm wondering if you expect any of that seasonality to somewhat offset the ongoing outflows? And then, second, I just noticed that the equity and the fixed income separate account flows were better this quarter. And I apologize if you covered this, but which managers would that be, and what accounts for that?

Well, Cynthia, on the money funds, I think you're right. It would be hard to predict. We have observed over many years a phenomenon of money coming in close to year end. But I'd be hesitant to overlay that to this year.

And on the equity and fixed income separate accounts, some of that was funding in the fixed income side of mandates that we won before and timing of when they get funded. We did win some new ones that aren't funded yet. The other thing I'd point to there is our separate SMA business within fixed income. That has been bubbling around.

It's up to a couple hundred million. It had been kind of a de novo business for us. So we are seeing some traction on the SMA side for fixed income.

Great. Thank you.

Seeing as there are no further questions at this time, I'll turn the floor back over to management for any closing remarks.

Thank you. That concludes our call. Thank you for joining us today.

This does conclude today's teleconference. You may disconnect your lines at this time and we thank you for your participation.