Practical analysis for investment professionals
22 January 2018

Where Are Fees and Expenses Not Costs?

In the Often-Alternative World of Alternative Investing

We “properly” don’t consider “performance-based compensation” to be a “cost of [investment] management” and “incentive payments are not included . . . [as] an expense.”

Representatives of large endowment investment offices made these statements, according to Charles Skorina, a leading chief investment officer (CIO) headhunter (he is paid to know who is good and who is not and tracks this closely).

And yes, you read that correctly.

Apparently, these leading investors don’t view incentive fees as costs, even though they are dollars paid to investment managers and can reduce returns by 20% over a set hurdle rate.

Also, keep in mind that this doesn’t mention expenses, which in the limited partnership (LP) investment world, generally aren’t considered costs when calculating net-of-fee performance.

As an example, we commonly see language like the following in LP investment reports and fund offering documents:

“Performance is net of management fees, but does not include incentive fees and are gross of the fund’s expenses, which generally include overhead and administrative expenses, including filing fees, legal expenses, tax preparation expenses, administrator’s fees and the fees associated with an annual audit.  In addition, performance figures do not take into account expenses relating to due diligence, research, investment related travel expenses, and fees associated with external manager background checks incurred by the fund.”

Even though I couldn’t help going “whew” after literally cutting and pasting this from a presentation I recently received, nothing is legally wrong here.

This is totally compliant: All is disclosed properly for experienced, “sophisticated,” and “accredited” investors.

The problem, however, is that even after spending over 25 years in this industry at senior levels — in a past life I was a managing director at a few large investment banks — I still find myself learning.

Unfortunately, I’m not alone.

In 2015, the Commonfund Institute, an organization viewed as one of the best sources of endowment investment returns and practices, published a paper titled, “Understanding the Cost of Investment Management.”

After receiving data from approximately 700 top endowments — Ivy League colleges and other leading institutions included — the authors stated that:

“. . . unlike other factors that affect investment returns . . . costs are almost certainly the least well understood.”

They then went on to say:

“. . . the fact that almost 15 percent of [survey] participants did not provide cost data at all suggests that they may not have known what their costs were or were uncertain about them.”

Related to all of the above, the below chart and quote from the Skorina report are illuminating:

 “ . . . only 18 percent [of respondents] included incentive and performance fees paid to asset managers, despite the fact that nearly 85 percent . . . reported having asset allocations to alternative investment strategies.”


Considered to Be Investment Costs*

Considered to Be Investment Costs*

* Percentages represent how many endowments said they consider the above items to be costs of investment management.

Source: Chart data and general format derived from the October 2015 Commonfund Institute report, “Understanding the Cost of Investment Management.”


I’m also wondering how 23% of endowments over $1 billion, and 14% of all the respondents didn’t even view asset management and mutual fund expenses as costs.

Finally, call me an unsophisticated investor, but I just don’t understand the following statement from an Ivy League investment office quoted by Skorina:

“Consistent with prior reporting and conventional accounting . . . performance-based compensation [is not] a cost of [investment] management.”

The last time I checked, all fees, expenses, or compensation paid to a consultant, investment manager, etc., are costs.

I’m not sure who else thinks this way, but when academic reports written by educators from Harvard Business School find that “private equity funds . . . charge average fees of 6% per year,” it seems like all investors — institutions of higher learning included — should spend a little more time educating themselves on how much they actually pay for investment management.

By the way, in my book, this doesn’t all fall back on investors. As I recently wrote, I think the investment industry can do a significantly better job of providing “simple plain language disclosures” of all costs.

Until this changes, however, Caveat “Sophisticated” Investor.

What is my recommendation to all CIOs, trustees, and UHNW family offices that have fiduciary responsibility?

Some private equity and other alternative LP funds are worth it after all costs (please don’t forget taxes for individuals and trusts), but beware.

When true cash-in-your-pocket net returns turn out to be much less than expected or modeled — remember, IRRs can also be misleading — ignorance is no excuse if you don’t understand that expenses and fees are costs that reduced your returns.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ CSA-Archive

About the Author(s)
Preston McSwain

Preston McSwain is the managing partner and founder of Fiduciary Wealth Partners, an SEC registered investment adviser and multi-family office that is focused on high-net-worth investors. Previously, McSwain was a managing director at Neuberger Berman and Lehman Brothers, where he was instrumental in the growth of the firms’ UHNW trust and wealth management divisions. He began his career at State Street Bank & Trust. McSwain received a BS in Finance with a concentration in Investment Management from the University of Alabama at Birmingham. He currently sits on the board of the Overseers of the Peabody Essex Museum, and is a member of the Economic Club of New York.

4 thoughts on “Where Are Fees and Expenses Not Costs?”

  1. Adam Bragman says:

    Anyone making decisions for millions or billions of endowment dollars should be able to decipher what is/is not a “cost” and be able to make the proper adjustments to the misleading performance figures provided by these managers. Everything that ends in “cost” or “expense” is obviously a cost, if they can’t figure that out or they’re blissfully unaware of this they’re just hopeless.

    I don’t really blame the managers who are giving out performance figures gross of all fees though, even if it’s dishonest, misleading, and overall just not a good reflection on the investment industry. They’re going to make their performance look as good as they can LEGALLY. Whoever is responsible for regulating these managers, and what they’re forced to include in their performance numbers are ultimately responsible for this tragedy of logic.

    If excluding costs/fees from performance were illegal, this problem would cease to exist. But these managers want their bonuses and they like their jobs and they’re going to make themselves look as good as they can while not violating the law.

  2. Jennings says:

    We did an analytical take on this in the FAJ https://www.cfapubs.org/doi/pdf/10.2469/faj.v72.n2.1

    1. Sloane Ortel says:

      William —

      Thanks for sharing. I think your title — Fees Eat Diversification’s Lunch — is completely excellent. All the best!

      Sloane

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