I have a personal confession. For nearly 50 years, I\u2019ve missed the \u201cobvious\u201d reality: Fees for investment management are not low. They are high; very<\/i> high. When investors recognize this \u201cnew reality\u201d \u2014 that fees are not trivial but are crucial \u2014 the beautiful \u201cinside\u201d world of fund management will experience a powerfully disruptive revolution. It may not be sudden, but it is inevitable.<\/p>\n
Investors are not captives of the conventional practices of \u201cperformance\u201d investing. They have proven alternatives. The process of getting to the \u201cAh ha!\u201d moment can come through a few examples of how easy it is to miss (or misinterpret) reality.<\/p>\n
Sometimes it\u2019s due to deliberate deception \u2014 as when a magician has you concentrating on his left hand while his right hand does the trick. At other times, the pattern has not been seen and requires someone with remarkable powers of observation to point it out. Charles Darwin saw parallels between geology and biology; a good example being the theory of \u201cgradualism,\u201d the slow processes that shape the earth. \u00a0He studied this theory first hand during his voyage to South America and later applied it to his own theory of evolutionary biology. At other times, we humans miss the obvious due to various prejudices based on race, gender or religion.<\/p>\n
Framing \u2014 the way we deliver something \u2014 can make a major difference. And so it has been with investment management fees. For years, the industry has described fees with one four-letter word and one number as in \u201conly\u201d and \u201c1%.\u201d But take a look from a different perspective and you\u2019ll never again think, \u201cFees are low\u201d at \u201conly\u201d 1%.<\/p>\n
Return with me to Econ 101 and do a simple re-framing. First, let\u2019s agree that you already have your assets. So, the right way to quantify investment fees is not as a percent of the assets you have, but as a percent of the returns that the investment manager produces<\/i>. This simple first step into realism changes fees from a low \u201conly 1%\u201d to, assuming the consensus of 7% future returns on equities, a substantial 14%, and that leap turns out to be just a start.<\/p>\n
The second step is to recognize that all investors have alternatives. Index funds and ETFs both have proven to be reliable, are widely available, and easy to access. In their \u201cplain vanilla\u201d form, both consistently provide investors with the market rate of return at no more than the market level of risk, at a low \u201ccommodity\u201d cost of around ten basis points.[i]<\/a><\/p>\n “Fees for investment management are not low. They are high; very<\/b> high. When investors recognize this ‘new reality’ \u2014 that fees are not trivial but are crucial \u2014 the beautiful \u201cinside\u201d world of fund management will experience a powerfully disruptive revolution. It may not be sudden, but it is inevitable.”<\/p>\n<\/div>\n The third step in our economic analysis follows. As every shopper knows, all prices are relative to value, so savvy buyers compare price to value when considering their alternatives. For investors, the easy availability of index funds and ETFs at low, \u201ccommodity\u201d prices, invites comparison of incremental <\/i>value to incremental <\/i>cost on incremental returns to incremental fees. If index funds and ETFs are widely available at ten basis points, the incremental cost of active \u201cperformance\u201d investing\u2014when the \u201csticker price\u201d is 1% (or one hundred basis points)\u2014is 0.9% or 90 basis points.[ii]<\/a><\/p>\n Now we can see the true cost of \u201cperformance\u201d investing: incremental fees as a percentage of incremental returns. Very few active mutual fund managers have delivered 100 basis points of incremental annual returns. But if an active manager had been so unusually successful, the true or marginal cost would be 90% of that marginal value.<\/p>\n On closer examination of actual experience, active mutual fund managers have been falling short of their own chosen objectives. Over a typical twelve-month period, about 60% fall short of their own benchmarks. Looking over a longer term, about 70% fall short over ten years. Plus, those that fall short do so by 1\u00bd times as much as the winners get ahead of the market. So, the \u201cslugging\u201d average is worse.<\/p>\n The specter that now haunts \u201cperformance\u201d investing will not go away. It will get worse for a profoundly ironic reason. Active mutual fund managers are not failing to beat the market because they are not informed, skillful, expert and diligent. Quite the opposite; active mutual fund managers are unable to out-perform because so many active managers (including hedge funds) are so skillful, so well-informed, and so hard-working that few, if any, can out-perform their expert peers with any consistency over time.<\/p>\n The largest, most capable, best-informed, highly competitive, professional investors dominate today\u2019s stock market. So, ironically \u2014 and inevitably \u2014 almost no one in this magnificent crowd can expect to out-perform the others.<\/p>\n “For years, the industry has described fees with one four-letter word and one number as in ‘only<\/b>‘ and ‘1%<\/b>‘.\u201d<\/p>\n<\/div>\n At least as important for investors, whether individuals or institutions, there are no known ways to identify in advance which active mutual fund managers will, eventually, out-perform over the longer term.<\/p>\n This leads directly to the fourth step in our analysis. After adjusting for quality, as well as the frequency and magnitude of shortfalls, we find incremental fees for active \u201cperformance\u201d investing are well over 100% of value to investors.<\/p>\n The fact that investors have not broadly caught on \u2013 yet \u2013 is certainly not the strong protective moat that Warren Buffett so wisely seeks and celebrates for Berkshire Hathaway. Maybe that\u2019s why he and others have long recommended indexing for most investors. Maybe the main reason indexing and ETFs continue to gain market share is that more and more investors are recognizing the true cost of active \u201cperformance\u201d investing. The pace of change has been gradual, but is accelerating. Can the tipping point be far ahead?<\/p>\n Charles D. Ellis<\/b> is a member of Wealthfront\u2019s investment team, the author of Winning the Loser\u2019s Game <\/i>and, with Burton Malkiel, The Elements of Investing.<\/i><\/p>\n [i]<\/a> A basis point is 1\/100th<\/sup> of a percent so 10 basis points is 0.1% of assets managed<\/i><\/p>\n<\/div>\n [ii]<\/a> If you are investing in a taxable account it is even worse. Vanguard did a recent analysis where they found that, for the 15 years ended October 31, 2013, the median tax cost of domestic actively managed stock funds was 27 basis points (0.27%) higher than that of domestic index stock funds. Source: <\/i>Tax efficiency: a decisive advantage for index funds<\/i><\/a>.\u00a0<\/i><\/p>\n <\/p>\n<\/div>\n<\/div>\n","protected":false},"excerpt":{"rendered":" I have a personal confession. For nearly 50 years, I\u2019ve missed the \u201cobvious\u201d reality: Fees for investment management are not low. They are high; very high. When investors recognize this \u201cnew reality\u201d \u2014 that fees are not trivial but are crucial \u2014 the beautiful \u201cinside\u201d world of fund management will experience a powerfully disruptive revolution. […]<\/p>\n","protected":false},"author":81,"featured_media":7282,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"inline_featured_image":false,"footnotes":""},"categories":[1282],"tags":[1418,1298,1396,1319,1600],"coauthors":[618],"class_list":["post-4288","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-investing","tag-charley-ellis","tag-etfs","tag-index-funds","tag-mutual-fund-fees","tag-young-investors"],"acf":[],"yoast_head":"\nInvestors are catching on<\/h2>\n
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