5th July 2016
The fund management fee debate has reached new heights. In the last few weeks alone UK Prime Minister, David Cameron, has raised the issue in parliament; Warren Buffett harangued active managers at his annual bash in Omaha and Jack Bogle, founder of Vanguard, has held court on his long-held concerns on the value destroyed by high fees in active fund management. Hedge funds have borne the brunt more recently but active mutual funds and the investment industry’s latest contrivance, smart-beta, have also failed to escape their indignation. As well as winning the commercial battle they have, so far, been winning the intellectual crusade; excessive trading does indeed create higher costs and complex compounding fees do, for most of the industry, soak up the larger part of investors’ direct returns. By offering index products, passive funds have created an honourable social purpose for themselves; they have brought low cost investing to main street.
Although their arithmetic seems tautological, however, it is missing some pieces of a bigger puzzle. Investors increasingly have to account for what economists call externalities; wider consequences of their decisions not accounted for in standard financial models and theory. Environmental and social costs, for example, were ignored until sustainable investing went mainstream; now they are unquestionably a crucial part of successful long-term investing. Fees have their own externalities; they are not just the direct cost of investment and they have an impact way beyond the maths of compounding net returns.
The fee debate has largely focussed on the fixed percentage charged against all assets and competition has certainly driven that percentage down. Their basic structure, however, has been mostly untouched. Even in the hedge fund world, where additional performance fees are ubiquitous, there’s always a so-called ad valorem fee - higher than for active mutual funds – which all investors pay regardless.
Given the economies of scale in asset management there’s clearly a question of fairness - all of those economies accrue to the managers – but the investment industry has also figured out a neat trick. By offering an index as its product, or even just as its benchmark, it can cut costs and forget about broader economic performance. It can concentrate on building scale while the wider risks are left in the hands of clients and everyone else.
For index managers the solution appears straight forward; to cut fees managers should cut costs by cutting out decision making. The rise of indexation, however, hasn’t only happened because active managers can’t compete on costs. It has also happened because active managers haven’t yet devised a widely adopted fee structure that’s not ad valorem - one that accounts for externalities and secures their social purpose in a way that low cost index funds have, for now at least, secured theirs.
So what are the external costs of a fee model that promotes indexation, benchmarking and asset gathering? In short, having investors perform in-line with an index might be fine as long as passive investing doesn’t reduce the returns of the index itself. Unfortunately, there are myriad of reasons why it might.
Firstly, index funds are pro-cyclical; when markets are rising, index or benchmark driven managers can only do one thing when their clients invest – buy more of the index. Secondly, as more of the market is passive, its role as natural selector is diminished – successful new companies find it harder to raise equity capital and bad companies are not starved of capital in the way they should be. Thirdly, the oversight of corporations deteriorates even further; an asset manager that has to hold shares regardless cannot influence as much as one that has the final sanction of being able to sell them.
Finally, we should not ignore fairness. In fact, it’s at the heart of the fund management fee problem. A study by PwC some time back found that fund managers were trusted by just 12% of those polled - even less than bankers. This is serious; ownership of investment products is still at shockingly low levels and the social cost of such low participation might, in the end, be the biggest external cost of all.
So we are left with two questions; is there a fee model that discourages benchmark hugging and indexation, while reducing the external costs of the current active management fee model? And if so, why is it not widely used already?
The answer to the second question is down to human failing; small numbers scare us less than big ones - an illusion that’s clouded the fee debate more than any other. Performance fees, which put fund managers on the hook for the performance of the underlying assets, necessitate bigger digits in their explanation than the apparently de minimis fractions used to articulate normal management fees. To illustrate, suppose you could invest with one of two managers - each delivering a 7% annual return. The first charges you just 1% of your average assets each year, the second takes 10% of all your returns. Most investors would baulk at option two and yet it’s this manager that would deliver a higher net return in the end.
When it comes to the external costs of management fees a simple thought experiment frames a fuller debate. Imagine the whole investment industry was passive and charged 0.2% of assets which delivered a 7% return. What would the return on those assets need to be for a 10% industry-wide performance fee model to be justified while maintaining the industry’s social purpose? The answer is 7.4%. If a vibrant, decisive, fundamentally driven, active asset management industry was allocating capital the way it should - and paid only when the assets performed - we would only need society’s assets in total to become marginally more productive. In practice they would most likely perform significantly better as a consequence whereas, in this thought experiment at least, they are otherwise left to languish.
Performance fees on their own are also problematic but, in combination with a small fee to keep managers viable in tougher times, they can play an important role in aligning the interests of the investment industry and society more broadly. In the end we are left with a choice; do we accept the external costs of the current fee regime or do we look for a fairer fee model that rewards healthy investment behaviour? One that delivers a more responsible, resilient, productive and fairer economy? In the way that sustainable investment promotes sustainable behaviour by companies, fair fee investing would promote a healthier financial system – something we all plainly need.
Andrew McNally is the Chief Executive Officer of Equitile Investments Ltd.