Investment Management Fees Are (Much) Higher Than You Think

Categories: Portfolio Management
Charles D. Ellis, CFA

The following guest editorial was written by Charles D. Ellis, CFA, chairman of the Whitehead Institute, Cambridge, Massachusetts. It was published in the May/June 2012 issue of the Financial Analysts Journal.

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.”

A relatively minor anomaly is getting more attention: While asset-based fees have increased substantially over the past 50 years — more than fourfold for both institutional and individual investors — investment results have not improved for many reasons. Changes in the equity market have been substantial, particularly in aggregate. Over the past 50 years, trading volume has increased 2,000 times — from 2 million shares a day to 4 billion — while derivatives, in value traded, have gone from zero to far more than the “cash” market. Institutional activity on the stock exchanges has gone from under 10% of trading to over 90%. And a wide array of game changers — Bloomberg, CFA charterholders, computer models, globalization, hedge funds, high-frequency trading, the internet, and so on — have become major factors in the market.

Most important, the worldwide increase in the number of highly trained professionals, all working intensely to achieve any competitive advantage, has been phenomenal. Consequently, today’s stock market is an aggregation of all the expert estimates of price-to-value coming every day from extraordinary numbers of hardworking, independent, experienced, well-informed, professional decision makers. The result is the world’s largest ever “prediction market.” Against this consensus of experts, managers of diversified portfolios of publicly traded securities who strive to beat the market are sorely challenged.

If the upward trend of fees and the downward trend of prospects for beat-the-market performance wave a warning flag for investors — as they certainly should — objective reality should cause all investors who believe investment management fees are low to reconsider.1 Seen from the right perspective, active management fees are not low — they are high, very high.

Extensive, undeniable data show that identifying in advance any one particular investment manager who will — after costs, taxes, and fees — achieve the holy grail of beating the market is highly improbable. Yes, Virginia, some managers will always beat the market, but we have no reliable way of determining in advance which managers will be the lucky ones.

Price is surely not everything, but just as surely, when analyzed as incremental fees for incremental returns, investment management fees are not “almost nothing.” No wonder increasing numbers of individual and institutional investors are turning to exchange-traded funds and index funds — and those experienced with either or both are steadily increasing their use of them.

Meanwhile, those hardworking and happy souls immersed in the fascinating complexities of active investment management might well wonder, Are we and our industry-wide compensation in a global bubble of our own creation? Does a specter of declining fees haunt our industry’s future? I believe it does, particularly for those who serve individual and institutional investors and continue to define their mission as beat-the-market performance.

1. The announcement in February by the U.S. Labor Department that it will require more disclosure of fees to 401(k) sponsors and participants may help some investors do so.

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10 comments on “Investment Management Fees Are (Much) Higher Than You Think

  1. The most prescient part of this post is the necessity of managers to redefine their mission. In light of the volatility of the past 10 years, I imagine managers will begin trying to better educate their clients about risk-adjusted returns, making the argument that while they may not beat their benchmark consistently, they provide returns at a lower risk profile. Still though, this is a shift in marketing, not compensation structure.

    Can managers successfully train clients to believe the the fees they pay are for volatility management, not sustained out-performance?

  2. Mark Harbour said:

    One of the difficulties in assessing the relative level of fees is defining what services are included in their assessment. I believe Charles Ellis article is appropriate if you use an excruciatingly narrow definition (for active investment management only). While many financial advisors charge percentage of asset fees for their services, industry surveys (see work by Cerulli) classify advisor practices into at least four broad categories. The most narrow are services focusing on investments (perhaps even a specific asset category) gradually incresing in complexity up to an integrated wealth management approach including services such as financial planning, tax forecasts, estate planning, and so forth in addition to investment management services. I fear the general public lumps all advisors into the same evaluation bucket. It is like comparing fees one pays to a bookkeeper versus a CPA firm for an audit….are fees appropriate? It depends on what you are buying.

  3. Nice article. This is arguably THE number one responsibility/governance issue facing active fund managers. And it’s fascinating because of the linkages.

    Why do active managers waste so much client money on dysfunctional sell side & credit rating agency research Dysfunctional because it a) costs so much, IBM is said to estimate this around $460bn But also because b) it misses so many ESG/intangible aspects of corporate performance? Think health & safety in O&G, governance & risk in finance… the list is huge.

    Why are they so against any action on the FTT – see this paper from Dutch investors – when hyper-volatility and HFT is one reason why traditional active fund manager are so unable to show value for money?

    Why is the financial industry which is so good at fostering dramatic change on other sectors and itself when it wants to (eg London’s Big Bang) so addicted to talking and talking and talking and talking about the same ‘ol problem (relative return benchmarks, cap weighted indices etc) ad infinitum?

    But the comment that most got my attention was the view that investment management fees are not “almost nothing”. It reminded me how many investment managers still explain their disinterest in CEO pay on the same grounds.

    I wonder if there might be a link between these mindsets?!

    To my mind, this shows that if asset owners want to see a less dysfunctional, less hyper volatile market, then a good place to start is with the fees they choose to pay. I congratulate CFA Institute on this article and look forward to follow on articles on fees for hedge funds and private equity too.

  4. tyc said:

    A relative way to measure fee is to compare the active management cost to an index or ETF product cost. First look at the R square or Beta of the active manage product to its benchmark, and then find an index or ETF that is manage similar to the benchmark.

    To justify the higher cost, rather then comparing return results, I believe active manage product needs to better advice clients as to what they can offer (services, strategy execution and others).

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  7. The shifting from short term investing towards long term will certainly require a new figure : the long term investment manager. In this case a totally new function will be required for a lot of reasons. In this case they do really earn their own costs !
    I’m coordinating aThink Tank about “European Fund for Common Good Innovation” trying to connect Long Term Investing to Long Term Planning ai Institutional level : from the very first steps we see a large amount of work in deciding and monitoring.

    • Assnap Kined said:

      This article show the reasons I buy low cost index funds from Vanguard in an allocation that fits for my age and risk tolerance and simply rebalance once a year. I don’t make any changes based up Wall Street soothsayers or clowns (Jim Cramer should be in clown make-up when he does his show) and I don’t worry about helping an active manager or financial advisor send their kids to a nice college (or buy a nice car/boat/house/vacation property) with my money.

      Advisors should be there to help the client, not promote the “loser’s game.”

      Assnap Kined

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