A former colleague of mine at Dimensional Fund Advisors once remarked that we should erect a monument in honor of the individual who invented “basis points pricing” to determine money management fees. When markets go up, management fees go up even though the service being provided remains the same.
A simple hypothetical example shows why the money management business is unlikely to change the pricing model as long as investors fail to recognize the negative impact this model has on their investment returns. Assume a mutual fund has an annual fee of 1% of the total value of the assets being managed. The manager would earn $1,000.00 on an investment of $100,000.00.
If the market goes up 20%, and the manager is lucky enough to match the market return, the fee goes up 20% even though the service being provided has not changed. Markets do go up over time, significantly, and the fees being charged go up accordingly. It’s as if the manager is taking credit, and getting rewarded, for an increase in the value of the overall market. Over a 10, 15 or 20 year period the basis point pricing model moves a lot of money from the investor’s pocket to the manager’s pocket that has not been earned.
When markets decline, the fee goes down but no one would ever invest if the expected long-term return from the market was negative. So why should investors continue to accept this substantial drag on their investment returns? They shouldn’t!
A new pricing model based on a fixed price would be simple to implement for large separate accounts. Defined Benefit Plan accounts, large foundations, and wealthy individuals who have enough invested to create a separate account, should never accept the basis point pricing model.
Open-end mutual funds, which have multiple investors coming in and out, would require a more complex pricing model to solve the problem, but I refuse to accept the conclusion that it can’t be done.
Unfortunately, the transition to Defined Contribution Plans (which utilize Open-end funds) from Defined Benefit Plans (which use separate accounts) creates more incentive for money managers to maintain the current pricing model.
But it will change. The potential benefits for investors are too great to ignore, and the business opportunity is too good to be overlooked. If one money management firm leads, all others will be forced to follow.