March 23, 2012
How Much Is Investment Management Worth?
The question comes up a lot because there are several variables to consider. Like so many aspects of finance and economics, the answer is dependent on market conditions, the particulars of the strategy, the investor's expectations and assumptions, the time horizon, and so on. Even when the main issues are nailed down, there’s still plenty of debate for deciding what’s a fair price. It may be reasonable to pay above-average fees—perhaps even a lot above average—for certain types of management services, but the opposite tends to be the prudent rule due to our old nemesis: uncertainty about the future.
Moving beyond generalities, however, is tricky. What’s needed is a good benchmark, but that’s not always easy to find, especially for assessing diversified portfolio strategies. What is clear is that fees are all over the map. On one extreme, some index funds charge virtually nothing. As I noted recently, you can find U.S. equity ETFs, for instance, charging as little as 5 basis points—a mere 0.05% of assets. On the other side of the aisle, nose-bleed pricing is widespread. According to Morningstar’s software Principia, there are thousands of mutual funds and ETFs charging 1%, which includes 2,000-plus funds at or above 2%. There are even 100 or so products in the 3%-and-higher club. And if we go right up to the edge, a handful bite investors for 6% and 7%.
That’s just the beginning for climbing the fee scale once we consider the two-and-twenty crowd in hedge fund land—2% of assets and 20% of profits (assuming there are any, which may be a questionable assumption as a general rule, according to Simon Lack).
Paying up wouldn't be a problem if managers reliably delivered juicy results. Alas, that's the exception rather than the rule, which means that most investors end up paying too much—for both the funds they own and any investment advice.
So what’s a fair price for money management? The answer, or at least some valuable perspective, starts by considering what’s available at minimal cost. For example, you can build a broadly diversified portfolio with the major asset classes using ETFs for less than 50 basis points (0.50%). That wouldn’t mean much if the strategy was a dog, but for a number of reasons (as I discuss in my book Dynamic Asset Allocation) you can grab a fair share of the available supply of the global risk premium with a passive, market-value weighted mix of equities, bonds, REITs and commodities. For instance, my Global Market Index (a proprietary benchmark of the major asset classes) earned nearly 7% a year on a total return basis through the end of February 2012. Not too shabby, considering that the U.S. equity market (Russell 3000) generated a relatively light 4.8% a year over that stretch.
Rebalancing the Global Market Index to market weights at the end of every year would have boosted performance further by 100 basis points a year. Equally weighting the major asset classes and rebalancing would have increased returns by 300 basis points a year over the unmanaged GMI performance. The fact that these naïve strategies based on asset allocation and/or rebalancing beat most actively managed multi-asset class mutual funds is one reason why we should remain skeptical about paying high fees for portfolio strategies.
In other words, there’s no compelling reason to overpay for beta, either in isolation or when repackaged in a multi-asset class product. Most of what masquerades as enlightened money management ends up as overpriced beta strategies. The ruse may not be obvious to the untrained eye, which is why factor analysis is essential for evaluating money managers. All too often, the results of this test suggest that you can do quite well by simply using a mix of low-priced beta products and managing the funds with forecast-free strategies to reflect your particular preferences.
But let’s not go overboard. There’s value for the average investor in paying an advisor for some strategic-minded hand holding. The main challenge in harvesting risk premia is less about choosing asset classes and managing the asset allocation than it is about staying calm when markets turn volatile and mustering the discipline to act at the most opportune moments. Sounds simple enough, but excelling on this front is rare. A key reason why rebalancing tends to earn a premium is because most investors (individuals as well as institutions) don’t reset their portfolios at all or do so in a suboptimal fashion so as to miss most of the opportunities.
As a result, paying a fee can be worthwhile if an advisor helps you exploit the major building blocks of earning attractive risk-adjusted returns through time—asset allocation and rebalancing. But there are limits here as well. As a rough estimate for figuring out a fair price, 50 to 100 basis points is reasonable for securing informed counsel. If you’re convinced you’ve found a superstar advisor, maybe 150 basis points is acceptable, although that's probably pushing it since true superstars are far and few between.
Remember too that advisor fees are in addition to the underlying fund expenses. Let’s assume a 100-basis-point fee for investment counsel plus 50 basis points for a portfolio of ETFs. That’s 1.5 percentage points off of whatever you earn, year after year. It doesn’t sound like much, but it adds up. For those who pay substantially more, the odds of earning a decent, much less stellar return fall dramatically.
Keep in mind too that we still haven’t factored in trading costs, commissions, and taxes. At the end of the day, it’s not unusual to fork over 200 basis points a year when all the costs are tallied. If you’re not careful, the price tag could go even higher. The worst-case scenario: you wind up paying a lot for mediocre or even misinformed advice.
In short, there are many pitfalls when it comes to expenses in the investment world, many of which eat away at returns quietly, virtually undetected if you’re not paying close attention. That didn’t matter much in years past, when risk premiums for betas were lofty. But if a decent returns will be tougher to generate in the years ahead, as I suspect is a reasonable assumption, overlooking expenses threatens to take a bigger, perhaps fatal bite out of your net results.
The good news is that keeping expenses low is easy. The problem is that most investors aren't monitoring this aspect of money management closely, if at all. No wonder that most investors earn dismal returns in the long run. One reason is that they’re overpaying for beta and for investment advice. Even worse, many investors in this infamous club don’t realize that they’re being gouged.
Posted by jp at March 23, 2012 10:48 AM