Quickly flip through a stack of bills on your desk. I am not asking you to get upset at how much you owe the electric company, your cellphone carrier or the cable provider. I just want you to recognize that all your other service providers, save money managers, tell you exactly how much you owe in dollars and cents.
Now dig out your latest brokerage or mutual fund statement, and try to figure out how much you paid to have your money managed. Ill keep writing while you flip through your financial statements.
Money management is one of the most ingenious businesses on the planet. Its not their brilliance at managing money that stands out. Not at all. As a whole theyre mediocre at their central task, but they are superstars when it comes to billing. The key to their billing success derives from the fact that they dont charge in dollars and cents. Money managers prefer to debit you in basis points. If your mutual fund charges you 150 basis points per year, which is 1.5 percent of your average account balance, you owe $150 per year on a $10,000 account. This charge covers management of the money, accounting and marketing. Most of you also pay a separate charge, called a 12b-1, which covers your mutual funds marketing expenses. You might be a bit more reticent about the fee if you were writing a check for $150 every year.
Steep price to pay
Charging in basis points and having you pick up the marketing expense only begin to demonstrate the cleverness of the money management industry. They dont need to send you a bill. Instead, they quietly debit your account during the year for the $150 in small amounts, so you dont even notice. Its all perfectly legal and spelled out in detail in the prospectus. As long as money managers are talking basis points, youre not quite as focused on how much youre paying for their services. The industry works the same magic with sophisticated institutional investors. No hedge fund manager in his right mind would tell a client that a $200 million mandate is going to cost them $4 million in management fees, plus another $4 million or $5 million in performance fees. It sounds much better as: We charge the standard 2-percent fee, plus 20 percent of the profits. Believe me, this form of billing works.
Im sure youve stopped searching for the amount you paid to your money manager as youve either read the previous two paragraphs or realized on your own that the amount is not to be found. Whether its 150 basis points or $150, it doesnt sound so expensive. But it is a steep price, because the industry wants you to look at the fee as a percentage of your average account balance, not as a percentage of the amount of money they make for you.
Returns vs. fees
Think about it this way: Why would you pay anyone a fee for managing the money you already have? You could put the money in a bank or Treasury bill (granted at a very low rate of interest), and you wouldnt owe a management fee at all. So the real question is how much of the increase in the value of your investment is going to be paid out in fees. Lets assume your $10,000 account increased by 8 percent, or $800. The annual fee would be about $156 (in this case the average balance was more than $10,000 during the year because of appreciation, so the fee is more than a flat $150).
You paid $156 in fees to generate a gain of $644 (before taxes). Nearly 20 percent of your profits went to pay fees, and were not even looking at trading costs. It doesnt much matter if you invest in a bond or equity fund, a hedge fund, or private equity. Its going to cost you somewhere between 20 percent and 40 percent of the gains in your account to pay for the care and feeding of the manager and associated expenses. And, if the investment doesnt work out, youll still have to pay a fee. Now thats a great business model ... for the industry.
Most money managers advise clients to focus on their returns and not the fees. They argue that if the returns are good, the fees are well worth it. Unfortunately, you have to agree to the fee schedule before the manager produces investment results and, of course, most of the returns are mediocre. You cant control the markets, and you are unlikely to ever get a properly itemized bill from a money manager, so you might as well drive down those basis points as far as possible.
Andrew Silton is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/