Money Management Fees (It’s time for a change!)

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.

6 Comments

Filed under Investments, Investors

6 responses to “Money Management Fees (It’s time for a change!)

  1. Charlie

    Couldn’t agree more Dan. Some form of fixed fee and a small share of the success in growing a clinets funds seems like a good place to be. Leaving the question open as to what model to build that would fit those parameters.

  2. Bo

    Dan:
    I think you should fix Congress and all the problems they have created over the last 5, 10, 20 years before you “fix” the mutual fund industry, wherre competition is fierce. The country needs your leadership.
    Bo

  3. Matt

    Hi Dan, I’ve been enjoying the blog. I was amused when I saw a friend I know well on the news holding a sign that read “eat the rich,” during an occupy movement. The comical portion of this is that she is holding the sign in front of the money management company that takes care of her trust fund that she inherited from her dad. She’s single, in her 30s, and has never had to work. I feel investors are getting a raw deal because people are too lazy to educate themselves/research something that is essential in today’s life, money. I’m sure a caveman would know everything about a rock before he traded it, but we have lost that energy. I’m not going to wait for the President or Congress to change the point system; I’ll be dead before that happens. We talked about the advantage of passive mutual funds (index) charging a quarter percent compared to active investing funds charging a full point plus, but what about a dollar cost averaging set up on individual shares. Takes more research, but I’d rather spend the time learning if a company makes money rather than holding a sign. People get rich and burned on speculation. If you don’t like the risk, invest in what you use. You take control of your own finances and you don’t have to hate anybody because you feel like they lost your money. Mutual funds are so large, money managers don’t have the time you think they do to do the required research on individual stocks in their fund. Money managers also take the whole summer off and hang out in the Hamptons, good market or bad, because they’re making a percentage off investor’s total assets (like you said above). They just invest in what the guy/girl sitting next to them invests in. If money managers all invest together and lose, we just call that a bad market and they keep their jobs and stay in their lofts on 5th Ave because there is nobody to blame. If they win, they’re heroes. There’s no accountability for money managers. But I’m not going to hate them for that because I’m too lazy to invest on my own. I know my parents spend a few hundred a week at Costco and it’s always full, I think I’ll start investing there. Thoughts?

  4. Greg Keady

    Hi Dan,
    There is a great deal of merit in your thoughts, which not only presents a challenge to fund managers but also to finacial advisory firms that derive their revenue on a similar same basis.

    Right now in Australia we have an interesting scenario emerging whereby the Accounting Professional & Ethical Standards Board, which represents the various accounting professions (CPA, CA and others), is potentially poised to move ahead of the regulators and outlaw its members from charging fees as a % of funds under advice. More details are expected in the next few months.

    Whilst this may be seen as quite radical by many in the financial planning sector, there is no denying that it will capture the attention of consumer advocates and the broader market at large.

    I expect it will be a real wake up call for the financial planning community who have relied for too long on the collective ignorance and lack of education of the consumer in really understanding not only what fees they pay, but the impact of excessive costs over the the long term.

    It should be a very interesting year.

  5. Dan,

    This is the natural evolution of your central theme–that investment returns aren’t manufactured by managers but belong to the investors who risk their hard-earned capital to create economic growth–and to generate returns that are theirs for the taking.

    You’ve done as much as anyone to promote and honor this crucial symbiosis between people and business. I hope you’ll never stop following where this leads. Anyone who knows you knows it’s heartfelt, and that it can’t help but continue to improve the finance industry and the lives of investors.

    Geno

    • Jeff

      Dan,

      If your comments are directed at actively managed mutual funds, especially those that are “closet index funds,” there is no fee, fixed or otherwise, that is appropriate. If your comments are directed at index funds, such as those offered by Vanguard and the ETF companies, I agree that a fixed fee is appropriate. It takes only so much effort to buy the same 500 stocks in the S&P 500 or 2000 stocks of the Russell 2000, in the same percentages, and at the same time that the indexes are reconstituted. The constantly moralizing Bogleheads should consider putting that in their special pipes and smoking it.

      If, however, you’re suggesting a firm like DFA should go to a fixed fee scheme, I disagree. Investors in those funds have derived exceptional value from DFA’s science, innovation, trading skills, management, securities lending policies, focus, consistency, and more. DFA deserves the value they’ve added, and as an investor in their funds I want them to be well-rewarded and stay motivated to continue to stand head and shoulders above their “competition.”

      Furthermore, assuming that a pretty fair percentage of DFA’s fees went to supporting and compensating you and your advisor staff, it’s fair to say that thousands of advisors, who probably would not have otherwise, transitioned from the “dark side” and embraced asset class investing to the benefit of millions of investors. A fair number of these investors are working class mom and pops who were constantly taken advantage of by Wall Street and active management. I’m not sure a fixed fee scheme at DFA would have accomplished as much or added as much value net of those horrible AUM-based fees.

      As for the other clients of the advisors who use DFA funds, most are millionaires and can certainly afford an average fund expense of 0.3% for what they’re receiving in return. Most became wealthy selling products or services at a price a willing buyer would pay and both parties won. Why should it be different for DFA? Is that not what a free market produces? If competition drives DFA’s fees down, so be it. But the fact is, DFA has no real competition because they do their job so well. What’s amazing to me is that they charge as little as they do. That speaks to integrity, not greed.

      Finally, most advisors using the DFA funds have a AUM-based fee, for good reason. Most add substantial value to their client relationships because they are financially (as well as ethically) motivated to assist their clients at all times to be smart, disciplined, and unemotional about their investments so that they grow and achieve agreed upon objectives. They’re not accountants gathering numbers once a year to put on a tax return. Most are educators and counselors in an ever-changing, fear and greed-driven business for clients who can not stay the course on their own. In other words, the advisors earn their fees.

      Jeff

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