Federated Hermes, Inc. (FHI) Earnings Call Transcript & Summary

Okay. Thanks, everyone, for joining our usual fireside chat. I'm Brian Bedell, the broker asset manager and exchange analyst at Deutsche Bank. And we are excited to have Tom Donahue and Ray Hanley from Federated Hermes joined us again this year. For those of you who don't know, Federated is one of the largest asset managers with over $600 billion in AUM, and it's based in Pittsburgh, but has offices across the country and has certainly extended its global reach now with the acquisition of Hermes -- 60% of Hermes Asset management 2 years ago, which at that time, at $46 billion in AUM. Tom has been with Federated since 1993, and he's been the CFO since 1996. And we also have Ray Hanley here, who is Head of Investor Relations and President of Federated Investors Management, which is the finance and administration arm of Federated. And Ray has been with the company since 1985. So again, we're very fortunate to have 2 multi-decade veterans with us on the line. Again, thanks to both of you for being with us today.

So I'll start out with some questions of my own and leave some time for questions for the participants. And just some quick instructions on that. You can ask a question via the web portal or you can e-mail me at [email protected], whichever is easier. Maybe we could start at a bit high level, Tom or Ray, or both of you. So obviously, the markets have been very challenging so far this year with extreme amounts of volatility and economic certainty. So how would you describe how your client base has generally reacted and how have you seen asset allocation shift? And maybe if you can give us any kind of update on assets and flows so far this quarter?

Yes. Great, Brian. Thank you, and thanks for having us. This is Tom. Hey, you're right. The whole experience has been very challenging, as you said. Of course, the impact on those with loved ones infected has been devastating. And while business has nothing to do with that, we will get on to business. What's been amazing to me is our employees' response across the company and around the globe, it's really been remarkable. The work-from-home ethic, resiliency, and their dedication shows up with how we've dealt with our clients and how our clients have reacted to that, which has been very strong positive response to us. Our regional consultants have conducted extensive client outreach. We've increased the frequency of our best thought leadership from our portfolio manager and their deep and broad experience has been invaluable. Our call center staff, they were able to adjust overnight to take calls -- client calls from home. Our clients have actually expressed gratitude with how our teams have responded, both in terms of the frequency and the quality of interactions. And my term forward is it's remarkable. Now on the asset allocation shifts in mid-March to risk-off was quite significant. Like others in the industry, we saw a strong reaction in the bond market disruption. Combining funds and SMA net bond redemptions in March were $2.2 billion and with equities negative, about $600 million. Within equities, however, though, we saw pockets of inflows even in March, so the Hermes SDG Engagement Fund was up $98 million, Kaufmann Small Cap Fund was up $75 million, and we had inflows into the Prudent Bear alternative strategy of about $170 million. Of course, Brian, the real story was the big money market inflows. Recently, we reached $480 billion, $85 billion or over 20% from the pre-pandemic levels. Government funds led the way with inflows. Prime fund had some early bumps, as I think we all know about. But then we started to have inflows after the Fed stabilization actions. For Q2 through mid-May, the combined funds and SMA's fixed income has actually returned to net inflows of about $1.1 billion, and that's been led by flows into our high-yield area. While combined fund and SMA equity flows for Q2 through mid-May are negative at about $1.3 billion, about $1.1 billion or 85% of this occurred in April, which we believe some of it was March activity in the SMA model-driven portfolios. Just to give you an update on recent assets at Federated -- Federated Hermes as of May 21 and actually at Hermes as of May 15, managed assets were approximately $644 billion, including, I already mentioned, the $480 billion in money markets, $73 billion in equities, $70 billion in fixed income, $17 billion in alternative, $4 billion in multi-assets and just a breakdown of the money market mutual fund assets, their level is $363 billion. So long winded, I think I answered all your questions.

Yes. No, that's -- everyone containing their models on a mark-to-market basis. That's helpful. And it's interesting on the perspective of the allocation shift. Obviously, money markets has been a huge positive, especially for your company, but in terms of just moving into cash for investors in terms of, obviously, deleveraging and taking the risk off in the markets. But if you can talk about maybe the diversity of these -- of the money market inflows that you've been seeing in the first quarter and in the second quarter-to-date? And which channels they're coming from? Like for example, what portion do you think are coming right from retail brokerage cash sweep vehicles versus, say, institutional allocations or corporate treasury?

Brian, it's Ray. I'll talk about the channels a bit. So we now reported kind of a consolidated view of institutions and intermediaries. And so the lines get blurred a bit. But the money market balance has really increased for all the client types, but we've had the strongest growth for institutional clients, where that's been about 90% of the growth that we've seen this year. And so that would be bank trust, other intermediaries that we put into the wealth management category and corporations will be a part of that as well. And so that leaves about 10% of the growth that came from largely through the broker-dealers and the sweep type of products. That's as close as we get to retail, still through in intermediary.

Okay. Okay. That's interesting. I guess if we maybe just thinking going forward a little bit, I mean, it's always hard to predict this, of course. But do you think based on the inflows across those channels, especially on the institutional side, that those assets could be sticky or remain sticky even if we get a sustained equity bull market like we've had in the last several weeks?

Yes, Brian, stickiness of assets is a really important thing to us. And if you pull out our deck or have anybody listening later on can pull out our deck of slides on Page 13, we have my favorite chart on there, which really the summation of the chart is that we end up seeing higher highs in money fund assets and higher lows as the market goes to all these cycles. I mean, the chart goes back to 1994, and you could follow the money stock and the S&P 500. And our money fund assets put right in there along with the industry. And you see that during the switchover to risk on as equity values increase, money market funds may decline but then they tend to stabilize and eventually grow during bull markets has. Of course, money funds are important cash component of people's portfolio and as their portfolio grows, the money fund grows. And you can see that on the chart with just the basic money stock has a compounded 20-year more growth rate of 6%. So I think we end up with sticky assets, the higher highs and higher lows is our way of driving it.

Yes. So yes, it's a definite sustainable organic growth through cycles is, I guess, sort of one way to say it. Maybe just while we're on money markets. Maybe if we could just touch on fee waivers for a second. I think you guys talked about $3 million of fee waivers in the second quarter based on the current rates and AUM levels. But how would you think about that as we sort of move through the year if LIBOR rates continue to compress? Any sense of sort of an outlook of where that could go into the third quarter?

Yes. Well, sort of answer -- we'll talk, but we're not going to answer that directly. We're not changing our $3 million forecast for Q2. But if you look back in the '08, '16 low rate period, about 80% of the waivers we experienced came from government funds as prime funds and muni funds generally when they were able to have enough yield in the portfolio to cover the expenses, at least of the institutionally priced funds. And Ray can go over a bunch of the more variables involved and why we won't predict.

Yes. We've gone through some of these, and we put it in our disclosure. But there's just a -- it's a multi-variable analysis. And so we have multiple flavors of money market funds, treasuries, agencies, prime and muni and some of those can buy repo and some don't. One point of interest will be whether the Fed restores the 5 basis point reverse repo rate, which was in effect, really close to the last low rate cycle. We think they will, but they haven't yet. Another variable would be the shape of the money market fund curve, which -- while money funds are thought of a short duration, they are, the individual instruments can go out as far as 397 days. So knowing how long the conditions last and what do the investors do? Do they move around between the different types of money market funds, what are the asset levels, all of these things would have impacted the number that turns out to be waiver impact. And so that's why trying to come up with that number of variables and range of outcomes makes it something that's just tough for us to do.

Yes. Yes. No, no worries. It's sort of our job anyway, I guess, to try to come up with estimates on that. But maybe just switching over to taxable bond funds. I mean, obviously, the industry took a big hit in March. Maybe just talk about how your fixed income franchise held up during the time. You mentioned the flows did turn positive so far quarter-to-date. I guess, maybe your view of do you see clients reallocating back to fixed income in a more sort of sustainable way, given sort of the search for yield?

It's hard to say that there have been such extreme generations. I mean, March was frankly different than conditions we've ever seen before in terms of the being spread across the whole -- seemingly the whole spectrum of the bond market. It's good to see that things have stabilized and in fact, moved back in to inflows. And there is a search for yield. And I think that's evidenced by the fact that we've had the most success in the high-yield part of our business, which we have a deep theme that's been together for a very long time. And the record there is just outstanding. The institutional high-yield bond funds, kind of the flagship strategy, and it's in the top decile, top quintile really over everything from month-to-date, year-to-date, all the way out through 10 years. So certainly, the interest there for us is a combination of both search for yield and also having an outstanding product. The other place people looking is for diversification approach within fixed income. And so our total return bond fund had, like everything in March, had debt redemptions. It's back to having net inflows. And it's bumping up against the top quartile for its most recent 3-year trailing record and recently got a 4-star move back to a 4-star rating. So yes, in terms of yield, but also with a bias towards some diversification and quality.

Yes. That makes sense. Maybe while we're talking about specific funds, if we can touch on strategic value dividend, obviously, your largest equity strategy. How you think that's been performing in this market? And what do you think it will take? Obviously, it's differentiated within its Morningstar category, but what do you think it will take for that strategy to see sustainable net inflows?

Yes. It's a great fund and a great strategy. It's high-quality, high-dividend yielding. It ought to be attractive right now in the current low interest rate environment. We kind of look at this and say, it's attractive to buy the dividend stream right now and that its price is on sale. The strategy still has strong growth sales and both the SMA and in the fixed income. We love it. It's a great strategy. Our clients understand it, for the most part. Regional consultants over time have put a great effort in continuing to explain the merits of the strategy. And just by your question, we too look forward to it, returning to net inflows. We just don't know when [indiscernible]...

Yes. It's the same. Is that the way for all the equities?

Just to add to that. I mean, this is a strategy that has generally outperformed when the broad market has had downturns. But the situation we had in March and into April was just essentially just such large-scale selling that there was really no place to hide. And so even though the strategy outperformed its dividend counterpart, it was not immune from the market conditions that we saw in March into April.

Right. And how are they protecting -- and within that fund against companies that are cutting their dividends, I know there's been a few in the financials, but do the investors view that as a pretty sustainable dividend level given the potential for a cut going forward?

Yes, they do. And it's done very well. It continued, at least through the first part of the year to have a number of -- a relatively high number of the -- it's a fairly concentrated strategy typically around 40 names or so. And when we looked at the end of the first quarter, 37 of the companies have raised their dividend. There was only one in the recent period that had a dividend cut, and it was not a particularly large part of the portfolio. So the dividend stream has held up well and the prospect for it look good as well.

That's why we say it's on sale, Brian.

Yes, exactly, right? No, that's always -- it's always good. And I know it's been a very consistent strategy. So that's something that, over the long-term should develop into stronger organic growth, I would think. Maybe let's shift gears a little bit to Hermes. ESG, obviously, has become an increasingly popular topic this year, especially. And I guess, have you seen a similar pickup in demand in your ESG product lineups since sort of the traffic in the -- its popularity has increased. Well, obviously, the Hermes franchise is positioned very well to benefit from this trend. To what extent do you think the ESG wave will drive more competition of similar type products into this area?

Yes. We're excited about Hermes. We were so excited that we changed the name of Federated, Inc. to Federated Hermes, Inc.

Yes. That's -- that certainly shows your excitement, yes.

And that really was -- we sat around, talked about how can we tell the market that we're going to embrace the tool set that Hermes has with their multi -- multi-year, 15 years longer experience with ESG, how can we tell everybody that we to adopt that? Well, let's go and change the name, and that will tell everybody that we're going to adopt it, and we are. And of course, also changing the name also implied that we are much more global firm. So that's kind of first big thing. When I asked about our ESG product lineup, it's important to realize that nearly all of our teams are integrating ESG factors into their investment management toolkit. All the legacy Hermes teams and the products are ESG-integrated, and they have been for a long time. They don't name their product ESG because they're all ESG. Now they do have some specifically named ESG products that for client purposes, they want their name on them. On the Federated legacy side of things, we've established a responsibility of -- to help our investment teams integrate the advanced ESG analytical tools. And more importantly, the proprietary insights generated by our unique EOS at Federated Hermes engagement business. And right now, over 90% of the Federated teams have integrated ESG data, research and proprietary tools into their processes and this has been led by the money market. They were the first ones to be fully integrated. Clients, Brian, are very interested in ESG, as you said, and they're also interested in our differentiated approach. So Federated legacy, Federated heritage is providing investment management strategies to bank trust departments, and other fiduciaries. So -- and to be clear that fiduciary obligations demand that the interest of investors and returns generated for the investors are the primary objectives. That's ahead of using the investors' assets in an effort to achieve societal benefits. Now Hermes has found that using ESG, as part of an active approach to investment management, has helped them to produce better returns -- better risk-adjusted returns over time. And for us, it's an educational process with clients to convey the ESG integration into legacy Federated products, like I said, the money market funds, the leader of it. And the Federated strategies give our portfolio managers additional tools to identify risks and we believe generate better, sustainable long-term investment results for our clients. So we have fully embraced it. I started out with Federated Hermes, and I'll end that with Federated Hermes, and that's what they are.

Yes. I know that it's obviously something that has been a major change for the organization. And maybe just attention to that would be the synergies. It's probably impossible to answer precisely. But maybe if you can either sort of state maybe how much organic growth has been lifted by the adoption of the integration of ESG factors across the legacy Federated franchise because clearly, clients would be, if they're demanding that, and they're seeing that in the Federated products, that would be a positive contributor. I don't know if you're able to measure that yet or at least just talk about it sort of qualitatively.

Yes, Brian. So as soon as you mentioned synergies, I talk about the German office, the sales office that we had at Federated that we turned over to the Hermes team, and they took them on. We had the Asia Pac thing that you might remember. We had a team, they had a team. They now have the team and some of our people departed and others joined their team. We're working on the Irish fund complex. In terms of actual dollars to point to, we started the 5 funds, and that's up 5 funds that Hermes is the adviser of and their U.S. '40 Act funds, they're up to around $80 million, and we have about $30 million or so in seed there. I think that in terms of working together and synergies that kind of the lead thing is the EOS business. And I think Ray has been pretty close to that and let him take you through the EOS because it's important in understanding what that brings and why it's so valuable to our team.

Yes, the EOS is the engagement part of the business that Hermes started about 15 years ago. And when we started up with Hermes back in mid-2018, we had mid-20 headcount of engagers, and we're now up into the mid-30s. And the EOS approach is essentially forming a syndicate of asset owners who pull their clout, so to speak, because even though they're all significant in their own right, they can have more effect united, and that's how we get to the over $1 trillion of assets under advice. Over the last year, EOS engaged with over 1,000 companies and almost 3,000 different issues and objectives. And it's a high-quality, high-caliber team. Now in addition to their accomplishments on the engagement side of things, the EOS operation was very attractive to Federated and has been important to Hermes in terms of marrying it up with our active management approach. And so the EOS team is broad-based, covers all the sectors, and we essentially can link them up, the fundamental analysts in the same sectors and it gives our fundamental analysts a window into the companies that EOS is working with for engagement purposes that we think gives us an information advantage to our processes. And you'll hear other folks talk about their ESG approach. A lot of it is based on databases, backward-looking. And even the very few firms that have been able to do engagement work have not been doing it for 15 years. They don't have the database and the history and the -- of seeing these issues over time, which we think leads to more effective, higher quality engagement. So we think of ourselves as essentially the leader in this area, and it will become -- it's already become prominent in our investment management operations, and that will only increase going forward.

Yes. That's a lot of great detail. I do have a couple of questions here, actually. One is around expenses and then one just a clarification on the flows. Just quickly on the flows. The quarter-to-date long-term flows. I think you said $1.1 billion positive on the fixed side and $1.3 billion out on equity. So are we sort of a negative $200 million, I guess? That's the first question for clarification. And then more on to look a little bit more deeply on the expense side, more of a longer-term question about expense growth over the next year or 2. To what extent -- or I should say, Tom, how do you think about balancing the long-term growth with the growth initiatives that you're working on with margin preservation?

Just on the flows, yes, it was about $1.1 billion positive, offset by $1.3 million (sic) [ $1.3 billion]. The positive was on fixed income, $1.3 billion on equity. So a net of about $200 million. And just be clear, whenever we talk about interim inter-period flows, we're always talking only about mutual funds and the SMA portion of our separate account business. We don't do the more regular reporting on the larger institutional accounts.

Brian, so on the expense side, it's much like when the Governor of Pennsylvania said, we -- all businesses are shut down, except for essential businesses, we are an essential business. And so we've been open every day, all day. Of course, we're working from home. Mostly. And -- but that thought process is leading how we're running the company. In other words, we're not out looking to cut expenses. We've had the T&E and the travel and entertainment and conferences. Nothing we did but it saves some money. We will look to see where things we can gain on the efficiency that people have realized from working from home and how can we continue that. We've actually started a -- ask all the employees, okay, now that you've seen how to do some things better, let's implement them into the future. But those are not expense cut ways of thinking about it. They're on how can we improve things. And we continue to invest in growth. I mean, the -- our exciting purchase that we mentioned before of MEPC and trying to grow the real estate business that Hermes has, and the buying the rest of HGPE and investing in distribution. They are exciting things. Ray already talked about EOS. We're still hiring more people in the U.S. on the EOS side of things. So we're obviously aware of what the margin is, but we don't manage to the margin. The cycle don't manage the comp. We get asked all the time, your comp ratio to this or this, and we don't manage like that. But we sure know what they are and continue -- we're going to continue to try to grow for the future. So that [indiscernible]...

Yes, that makes sense. I just have another question here on actually the active nontransparent ETF vehicles that have been approved in the marketplace. Is this something that you might try to license later this year if that product structure is finalized and you can see demand for it? Or is that something that you really want to take a wait-and-see approach on?

Yes. On the nonactive ETFs, we're in the process actually of adding a new hire. My brother likes to call this kind of new hire, a horse to ride. And so we will start that horse soon. We don't expect it to be a 2020 growth item. But it's another form of packaging of our great management teams. And I would say that we will be participants.

Right. Okay. Okay. And then another -- maybe this is -- hopefully, is a quick one here. But just the second quarter run rate from the deals, to what extent will that be accretive relative to the first quarter run rate, given the onetime fees and full quarter impact of the deal expenses?

Yes. We went through those a little bit on the call. And the real focus on those is our ability to take the little investments that we made. It will be positive and we expect it to be positive. But the real story is to be able to put the development arm with the rest of the team at the real estate side of things and to really be able to have a full control over the private equity business on the HGPE side, so that we're willing to invest and to try to grow that. Of course, the portfolio managers -- or the portfolio managers and they're running things. So control doesn't mean we're trying to tell them what to do. It's just that we put in our distribution efforts. We wanted to be able to direct how those go. So those are the really exciting things going on there.

Yes. No, that makes sense. And just -- we're almost out of time here. One last question coming in. Performance fees for the quarter, quarter-to-date, are you able to talk about those at all? Or is that just too early to do that?

Yes. That's too early for us. We're always get those right at the end of the quarter.

Yes. It's almost like a mark-to-market on that. But no, it's just that we did get the question. So anyway, we are fully up to our 35 minutes here. So anyway, any other closing things you guys would like to say?

We're looking forward to being able to see our employees across the table, at least from 6 feet anyway. And hope everybody stays safe.

Yes, thank you. And for all of you as well. And thanks so much for doing this virtual fireside chat. We all really appreciate it. So we will...

Thanks, Brian.

Yes, thanks. We'll talk soon. Thank you.