Wednesday, September 26, 2012

How we get away with it: investment management fees

How we get away with it: investment management fees

Quickly flip through a stack of bills on your desk.  I am not asking you to get upset at how much you owe the electric utility, your cell phone provider, or the cable company.  I just want you to recognize that all your other service providers tell you exactly how much you owe in dollars and cents.   Now dig out your latest brokerage or mutual fund statement, and try to figure out how much you paid to have your money managed.  I’ll keep writing while you look around.

Money management is one of the most ingenious businesses on the planet.  It’s not our brilliance at managing money that stands out.  Nope, as a whole we’re mediocre at our central task, but we are superstars when it comes to billing.  You see we don’t bill in dollars and cents, we much prefer “basis points.”  So your mutual fund might charge you 150 basis points per year, which is 1.5% of your average account balance (this charge covers management of the money, accounting, marketing [yup, most of you pay so the mutual fund can market their product with your money]).  So if your average balance during a year was $10,000, your bill will be about $150.  You might be a bit more reticent about the fee if you were writing a check for $150 every year and hopefully more as you’re expecting your money to grow.

In Exile (2000)

Mutual fund managers are even cleverer.  They don’t need to send you a bill.  They quietly debit your account during the year for the $150 in small amounts, so you don’t even notice.  It’s all perfectly legal and spelled out in detail in the prospectus.  As long as we’re talking basis points, you’re not quite as focused on how much you’re paying for money management services.  The industry works the same way with so-called “sophisticated” institutional investors.  No hedge fund manager in his right mind would tell a client that a $200 million mandate is going to cost them $4 million in management fees, plus another $4 or $5 million in performance fees.  It sounds much better as: “we charge the standard 2% fee, plus 20% of the profits.”  More importantly, it works.

I’m sure you’ve stopped searching for the amount you paid to your money manager as you’ve either read the previous two paragraphs or realized on your own that the amount is not to be found.  Well, you say, whether its 150 basis points or $150 that doesn’t sound so expensive.  Ah, but it is a steep price because the industry wants you to look at the fee as a percentage of your average account balance, not as a percentage of the amount of money they make for you.

Think about it this way.  Why would you pay anyone a fee for managing the money you already have?  You could put the money in a bank or Treasury bill (granted at a very low rate of interest), but you wouldn’t owe a management fee at all.  So the real question is how much of the increase in the value of your investment is going to paid out in fees.  Let’s assume our $10,000 account increased in value by 8%, or $800, the annual fee would be about $156 (in this case the average balance was more than $10,000 during the year because of appreciation so the fee is more than a flat $150). 

So you paid $156 in fees to generate a gain for your account of $644 (before taxes).  Nearly 20% of your profits went to pay fees, and we’re not even looking at trading costs. 

Here’s the point.  It doesn’t much matter if you invest in a bond or equity fund, a hedge fund, or private equity.  It’s going to cost you somewhere between 20% and 40% of the gains in your account to pay for the care and feeding of the manager and associated expenses.  And, if the investment doesn’t work out, you’ll still have to pay a fee.  Now that is a great business model . . . for the industry.

How can you drive these expenses down to a reasonable level?   Index funds, exchange traded funds, and other products that give you exposure to stocks and bonds, but take away the chance to earn a higher return than the stock or bond market averages.  What you lose is the patter of your money manager, who is confident he can beat the market and determined that you don’t ask too many questions about how much it really costs.

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