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06/13/2012

Investment Management Fees Are (Much) Higher Than You Think


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CFA Institute

Although some critics grouse about them, most investors have long thought that investment management fees can best be described in one word: low. Indeed, fees are seen as so low that they are almost inconsequential when choosing an investment manager. This view, however, is a delusion. Seen for what they really are, fees for active management are high—much higher than even the critics have recognized.

When stated as a percentage of assets, average fees do look low—a little over 1% of assets for individuals and a little less than one-half of 1% for institutional investors. But the investors already own those assets, so investment management fees should really be based on what investors are getting in the returns that managers produce. Calculated correctly, as a percentage of returns, fees no longer look low. Do the math. If returns average, say, 8% a year, then those same fees are not 1% or one-half of 1%. They are much higher—typically over 12% for individuals and 6% for institutions.

But even this recalculation substantially understates the real cost of active “beat the market” investment management. Here’s why: Index funds reliably produce a “commodity product” that ensures the market rate of return with no more than market risk. Index funds are now available at fees that are very small: 5 bps (0.05%) or less for institutions and 20 bps or less for individuals. Therefore, investors should consider fees charged by active managers not as a percentage of total returns but as incremental fees versus risk-adjusted incremental returns above the market index.

Thus (correctly) stated, management fees for active management are remarkably high. Incremental fees are somewhere between 50% of incremental returns and, because a majority of active managers fall short of their chosen benchmarks, infinity. And when market returns are low, as in recent years, management fees eat up even more of an investor’s return. Are any other services of any kind priced at such a high proportion of client-delivered value? Can active investment managers continue to thrive on the assumption that clients won’t figure out the reality that, compared with the readily available passive alternative, fees for active management are astonishingly high?

Fees for active management have a long and interesting history. Once upon a time, investment management was considered a “loss leader.” When pension funds first mushroomed as “fringe benefits” during the post–World War II wage-and-price freeze, most major banks agreed to manage pension fund assets as a “customer accommodation” for little or no money—that is, no explicit fee. With fixed-rate brokerage commissions, the banks exchanged commissions for cash balances in agreed proportions. The brokers got “reciprocal” commission business, and the banks got “free” balances they could lend out at prevailing interest rates. In the 1960s, a few institutional brokerage firms, including DLJ, Mitchell Hutchins, and Baker Weeks, had investment management units that charged full fees (usually 1%) but then offset those nominal fees entirely with brokerage commissions.

When the Morgan Bank took the lead in charging fees by announcing institutional fees of one-quarter of 1% in the late 1960s, conventional Wall Street wisdom held that the move would cost the bank a ton of business. Actually, it lost only one account. Thus began nearly a half century of persistent fee increases, facilitated by client perceptions that fees were comfortably exceeded by incremental returns—if the right manager was chosen. Even today, despite extensive evidence to the contrary, both individual and institutional investors typically expect their chosen managers to produce significantly higher-than-market returns. That’s why fees have seemed “low.”

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