Why We (Really) Pay Management Fees

Fees 24 Aug 2006

Retail investors tend to take management fees for granted.  Few people, other than industry comentators, seem to obsess about them even though we know they are relatively high in Canada.  We care more about gas prices than mutual fund fees.  In fact, on a $100,000 portfolio moving from the typical US management fee to the typical Canadian management fee has the same effect as a jump in gas prices from $1/litre to $1.50 a litre for a typical car.  Imagine the outrage if gas were $1.50 a litre.

Even fewer people ask what we get for our management fee dollar.  I’m not saying we don’t get our money’s worth.  But there is little agreement about what we should expect to receive in exchange for management fees.  Answering this basic  question will give us insight into other, cheaper ways we might construct our portfolios.

Many people argue that we pay for expected performance.  Yet if the market goes down and our mutual fund loses value, do we sue the manager for not generating returns?  Sure, we are disappointed.  But let’s face it, we all read the small print about returns not being guaranteed.  We might grumble, but if the whole market was down, we are not likely to blame our manager.

Which might suggest that we ought to pay management fees so our manager can beat the market.  When the market goes down 10% but our fund is only down 8%, we are oddly pleased.  But down 12%, and we grumble even more.  Do  we sue our manager for not holding up their end of the agreement?  No.  Which means we must somehow feel that we have actually received something of value – something the manager promised to do and actually delivered on – even though they lost money and underperformed their peers.

Worse yet, what if it became apparent that our manager’s investment techniques and strategies were not able to generate good returns after all?  After several years of underpeformance and losses, would we finally sue our manager for not holding up their end of the bargain?  Probably not.  Many funds underperform and many of these will likely fold after some time.  But few investors will argue that the manager necessarily breached their contract or was fraudulant.

The legal agreement between an investor and a manager promises that the fund manager will try their best to generate returns using a specific investment technique or style.  If there is one thing that the manager is on the hook to provide – it’s their best efforts to make you money.  To do this, the manager will spend your management fees on analysts, data, infrastructure, and of course, the appropriate profits.

But when it becomes apparent that our managers are not even making active investment decisions, not using our money to make unique (active) decisions – that’s where investors need to draw the line.

The best way to determine if our managers are actually making their own investment decisions is to examine their returns.  If those returns are highly correlated with the index, and you are paying 2.5%, you are likely paying way too much.

Answer this question: Assuming the market was up 10% for each of the past 3 years, which of these two scenarios would you prefer to invest going forward:

  1. “The Hot Hand Fund”: A mutual fund charged 2.5%, put the money into a 2x levered ETF at 0.20% for three years and pocketed the difference between 2.5% and the ETF price of, say, 0.20%.  The manager moved to Bermuda and came back after three years to a ticker-tape parade and a “best fund” award for his nearly 20% annual return.
  2. “The Loser Fund”: Another mutual fund charges you 2.5%, hires staff, peforms company visits, and spends money on research and compliance.  You like his approach.  But three years later, he had only produced 5% per annum returns.

If you said “#1”, you need to ask yourself two questions: 1) Why are so so sure the markets will rise again next year and 2) If you are certain markets will rise again, why are you not just buying ETFs on your own?

If you said “#2”, you realize what many investors do not.  Management fees pay for effort, not results. And “effort” is best measured by the extent to which the fund strays from the index.

When confronted with this question, the overwhelming majority of advisors say their clients (and therefore they themselves) would rather be in option #1.  Confronted with the fact that the manager actually didn’t do anything of value here, the response is often “My clients don’t care”.  But this “All’s well that ends well” attitude is dangerous for both advisor and investor.

It’s like buying a lottery ticket with a $1 million jackpot every week for 3 years and winning a total of $500.  You might be happy with your success – until you find out that there was no million dollar jackpot (!), no one ever won more than $1000, and all the money was spent on lavish offices for lottery executives. In this scenario would you say “All’s well that end’s well” or would you join a class action suit?

Recent research from Yale University suggests that more and more mutual funds have become “index-huggers”.  That is, their returns (and even their actual holdings as the researchers show us) have come to look remarkabley similar to the index.  With the growing ubiquity of indexing instruments such as ETFs, futures and swaps, index exposure can be purchased for a very low fee.  If many mutual funds are really just ETFs in drag, then they must be very cheap to manage now.  So why are we still paying 2.5% per annum for them?

One might say that the manager did not literally buy an ETF, it just looked from his returns as if he did.  But if that were indeed the case, the manager would still not have created any value.  Sure, you are welcome to feel badly for the manager, but index-hugging by any other name is still index-hugging. After all, there are many ways to hug the index beyond literally buying it.

The bottom line is that mutual funds have fallen off the wagon over the past 20 years and investors are enabling such destructuve behavior by placidly continuing to pay high (“active management”) fees without asking what they are getting for their money.

– Alpha Male

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