Why We (Really) Pay Management Fees
Aug 24th, 2006 | Filed under: Investment Management FeesRetail 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.
To continue reading this article please login (at the right) or click here to learn more about accessing our archives.
[…] We add that too often, (retail) long-only investors aim to “pay for returns†and hail their mutual fund manager as a hero if he simply produces positive returns †even if those returns are the result of easily replicable and extremely cheap market beta. To be sure, “exotic” beta returns may be a small part of the rationale to compensate managers. But we have advocated that investors should pay primarily for “effort†(as revealed by returns that do not simply track the index). Ineichen calls this effort “complexity†and also suggests it should be major element of manager compensation. To beta returns and complexity, he adds “skill†as the third element that deserves compensation. Thus, he proposes the following triangle to understand the fee drivers of various investment strategies (page 76): […]
[…] As we’ve argued before, investors should essentially be paying for tracking error, not simply performance. Riding betas up and down does not take skill - as author Alexander Ineichen pointed out in his book Asymmetric Returns (see related posting). In other words, investors should pay active management fees for active management, not simply for a short-volatility strategy (in the case of hedge funds) or an index-hugging strategy (in the case of mutual funds). […]