Back when I worked for a major Wall Street brokerage firm, one of my jobs was marketing my firm’s research to institutional investors, e.g., asset management firms, hedge funds, and mutual funds. The breadth of our research department was impressive. We had analysts all over the globe and our firm churned out a staggering amount of research every day. Someone once claimed that it would take an average reader nearly a week to read just one day’s worth of research.
Clients paid for our research by trading with us. There wasn’t a defined price, but rather an understanding that the more assets a client had under management the more trading they were expected to do in exchange for access to our research. While our top clients would enjoy occasional private meetings with some of our analysts, our research department was always walking a fine line between uniform dissemination of potential market moving research and possible allegations of front running.
In the early 2000s, some of the largest clients got wise to the fact that our research was basically a one-size-fits-all product and that they were paying disproportionately more for it than were their smaller competitors. Some clients figured that they were paying upwards of 20 million dollars a year for the exact same research product that we were providing to smaller accounts, which were paying us less than one million dollars in commissions.
The larger accounts pushed back, arguing that they were effectively subsidizing their smaller competitors and demanded that we re-price our research, basically putting an end to asset-based pricing for sell-side research.
Asset Management Industry
Much like the way we used to price sell-side research, with larger accounts paying more for the same product, asset management fees are almost always expressed as a percentage of the value of the underlying assets. These fees run the gamut from index funds that charge less than 10 basis points, to actively managed portfolios that can charge close to two per cent a year. Investment professionals are often quick to dismiss asset management fees as incidental or not meaningful.
But a closer look at these fees uncovers an industry that’s clinging to an antiquated business model, one that is unique to the asset management industry.
We’re going to start with our conclusion—that the only meaningful value asset managers bring to the table these days is the investment returns that they generate. So, if you highly value an occasional golf game, backward looking quarterly commentary letters, or computer-generated year-end tax information, this article doesn’t apply to you. Stop reading now and just keep paying through the nose.
It’s our view that asset management fees should be expressed (or at least viewed by investors) as a percentage of the investment return, which is all an investor is paying for. For example, if an investor is paying investment management fees of 1.5% of the value of his assets and the asset manager delivers a return of 10%, then that investor has in effect paid out ~15% of his return as a fee. If the return generated was only 5%, then the investor would have paid out ~30% of his return in fees. When one looks at investment management fees in this perspective, it’s clear that something is wrong with this model.
By way of history, asset-based pricing could be justified 35 plus years ago, when the investment management industry was very labour intensive and everything was done manually. Paper stock certificates were physically held on behalf of investors, dividend payment checks had to be collected and deposited, client statements were tediously prepared, and research analysts spent countless hours using slide rules to prepare hand-written spread sheets. One of the biggest selling points of mutual funds and asset management firms was that they would pass the economies of scale on to investors.
Fast-forward to today. With the benefits of modern technology, the asset management industry is now fully automated and human hands are rarely needed. Yet the industry has failed to pass the promised economies of scale on to investors.
Investors need to change the way they view asset management fees. How many people would pay their accountant a fixed percentage of their income, or even worse, their net worth, every year to prepare a tax return (particularly in the age of Turbo Tax)? Would anyone pay their attorney a yearly percentage of the value of their estate, in exchange for preparing a simple will that is updated occasionally?
The next time an investment professional dismisses his or her fees as just one or two per cent of the value of your assets, remind them of how hard you worked for those assets and keep the focus on the investment return and how much you paid for that return (or that round of golf). It’s time for investors to re-frame the fee discussion.
The asset management industry wants it both ways. They don’t want to be penalised for their assets under management, yet they fully expect their larger clients to pay disproportionately more for their own one-size-fits-all products and services.
EL CAP, Inc. is a Registered Investment Adviser registered with the Securities Division of the State of Vermont. The firm provides investment-consulting services to individual investors, corporations, foundations, trustees, and endowments.