When I started out investing, people talked only about stocks. Today, it is about funds. And there are all kinds of funds. Active mutual funds, passive funds, exchange-traded funds, hedge funds, private funds… In fact, we have more funds than securities today.
In case you have no idea what a fund is, they are entities that pooled money from different people to invest. And they are managed by investment management companies. For example, Franklin Templeton, Fidelity, Schroders, Black Rock, BridgeWater Associates so on, and so forth. As with all services provided in this world, nothing comes for free. So you pay fees to these companies to manage your money. But to be fair, it does cost a fair bit to run a fund. Because aside from the fund management company that gets its management fee, there are many others trying to take a bite out of the pie. For example, your sales guys, landlord, government, brokers, research companies, data providers, marketing firms, fund accountants, auditors, custodians, lawyers …
Fees — Your Fund Expense Ratio
There are many different types of fees. The bulk of it is lumped inside this thing called the fund expense ratio. It captures most fund-related expenses including the management fees and other stuff. What is not included in this expense ratio is the sales charge you pay to advisors or brokers who sold you the fund. But, not all funds have a sales charge. And in the case of hedge funds, which are open only to the high net worths and institutions, they have another fee called the performance fee. This fee takes the form of a cut on the profits they make for you. On top of these, trading related transaction costs incurred by the fund buying and selling securities are not inside as well.
This expense ratio, of which the management fee tends to be the largest component, varies from one fund to another. Based on Wikipedia which gets its numbers from MorningStar, this is how the average expense ratio looks.
Actively managed funds tend to have higher expense ratios with hedge funds topping the range. Similarly, funds dabbling in riskier assets such as stocks also have higher expense ratios than say bond funds.
Why Should You Care About The Fees?
The reason is simple. They eat into your profits, and often way more than what most laymen think. A “harmless” looking 1% can take a huge slice off your profits over time. Because the annual fee can be deducted daily, and what you lose at the end is also not just the fees you paid to the fund manager, but also the loss of potential profits on the fees paid.
Let’s do a simple exercise to compare the case where you invest in SPY (S&P 500 ETF) since its inception by yourself, and going through another fund that charges you 1% to invest in SPY on your behalf. The latter is a fictional example just for illustration purposes. Such rip-off funds don’t and shouldn’t exist (I hope). For convenience, let’s just called this fund RipOff.
If you invested $100K in SPY since 1993, you would have made around $1.2 mil in profits. However, if you go through RipOff, you will only end up with $882K in profits. $103K ends up in RipOff’s pockets as fees, and $209K is due to loss of potential profits on these fees. So the total cost to you — a whooping $312K just to get RipOff to do something as simple as parking the money in SPY for you.
To get a clearer picture, let’s take a look at the impact of various levels of fees on a $100K investment on SPY since inception.
As you can see, given sufficient time, a “mild-looking” fee of 1% or more can cost you an arm or leg. When the fees hit 2%, almost half of your profits are gone into thin air.
Pay Only What It Is Worth
So is it wrong for funds to charge fees? Absolutely not. You can’t expect businesses to provide you services free of charge. They have mouths to feed too. But you need to be discerning about what you are paying for and how much you are paying. If you are capable of doing what they do or better, then it makes sense to do it yourself. But of course, you can still opt for the easy way out and let them do the work for you. But paying a couple of hundred grand for that just sound too exorbitant.
Before you put that money to work in a fund, you might want to ask a few simple questions:
Does the fund manager have the skills?
For an actively managed fund, we want to see the value add from the manager’s active management. By value-add, I don’t mean the manager making more in terms of absolute returns. Many people mistook that as simply making more money. No, that is not it. Because you can beat a stock index that has a decent positive long term growth by taking on more risks. For example, you may concentrate risks on technology stocks, or use a little bit of leverage (but not excessive). But, getting more returns with more risk is a given. That has nothing to do with skills.
What we are looking for is evidence of skill i.e. is the manager consistently adding returns after we strip out the returns from taking on market risks. This value add is what we called the alpha. It measures the active returns of the manager. For simplicity, I will not launch into the details of alpha. If you are interested, you can read it in an earlier piece I wrote here. In any case, the majority of actively managed funds underperformed.
For passive funds that do mostly index replication, skills aren’t that relevant. They charge on average close to 0.5%. This fee is often also a function of their size. A large fund can operate with a low fee, but not a small one. But, in my opinion, this still borders on the high side. Their main advantage is enabling you to diversify using a lot less money and providing convenience. With tons of such offerings out there today, this is no longer a sufficient basis for high fees unless they are focus on a really niche market. So if anything, between similar products, just aim for the lower costs one.
Are the funds doing what you need?
You have to find one that addresses your needs. If you are already sitting on a good size stock portfolio, then maybe you want to look for a bond fund to spread out the risk. Or if you just want passive exposure to a particular market, then you should be looking at low-cost index funds rather than the actively managed funds. Or perhaps you are already a seasoned investor and looking to add an uncorrelated strategy to your current portfolio. Then a typical run of the mill long-only mutual fund is unlikely to meet your requirements. You will then need to look into alternative funds such as hedge funds.
Is the fund doing something I can do myself?
Many people thought professional funds are doing things that are out of reach. Because there is always this lingering thought that what they do must be rocket science and require a ton of resources. If you think along such lines as well, you will be surprised that some strategies are well within reach of the common man. This is made possible with the advent of low-cost index funds and ETFs, as well as ever-lower brokerage fees. For example, asset allocation type strategies are no longer off bounds. So is trend following, a popular strategy adopted by Commodity Trading Advisors (CTAs) for decades. And there are many more. Technically, these aren’t that difficult to understand or implement. In such instances, doing it yourself not only puts you in charge but saves you a significant amount of fees over the long run too.
Traditional means of setting fees are based on a fixed percentage of the fund’s asset size. This is not something unique to fund management companies. Many service providers revolving around fund management also charge their fees in the same manner e.g. brokers, fund custodians, fund administrators.
Today, fees are trending down as competition intensifies and clients get increasingly savvier. In the hedge fund space, we are starting to see some charging performance fees only on the Alpha or the value add they produce. From the client perspective, that is fairer, more aligned to their interest, and saves them a lot on fees as well. But of course, such a move makes the fund industry a lot less lucrative. And the established big boys who are already hoarding the market share sees no need to follow suit. So it may still be a considerable time before the industry gets revamped. Let us keep watching.
Originally published at https://investmentcache.com on September 21, 2020.