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Pragmatic Capitalism

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Why Noah Smith Gets Investment Fees Mostly Wrong

Noah Smith has a piece up on Bloomberg View arguing that a percentage fee on assets under management is a form of price discrimination. In essence, he says that a large investor shouldn’t pay 10X more in fees just because they have 10X more in assets.  The alternative is that asset managers should just charge a flat fee. This is an attractive line of reasoning, but I tend to fall under the thinking that the AUM % fee structure is the worst fee structure except for all the rest.  Let me explain.

First of all, for actual fund companies the AUM % fee structure is the only scalable business model.  The reason being that a fund that charges a flat fee structure would quickly be priced out of the market. If the XYZ Index Fund started to charge a flat fee of $5,000 for investing in its fund then multiple institutions could form partnerships which make them one investor in the fund. Imagine having to manage even a relatively small $100MM portfolio for $5,000.  A flat fee structure isn’t just regressive in this sense. It’s totally illogical for any fund that has fixed costs inside of its fund structure. A private fund like a hedge fund could better manage this situation than a publicly traded fund, but they too would ultimately be victims of a regressive pricing system. That is, their large investors would be illogical if they didn’t pool their assets inside of the fund or move their assets to a similar low cost version (which simply creates an unsustainable hot potato effect).  The only option to combat this form of regressive pricing is the AUM % fee structure.

Second, if the pricing structure was flipped then people likely would argue that the price is discriminating against poorer investors. In essence, they’d say that the market is rigged to help wealthier investors pay lower relative fees.  This would be a very odd view though.  It’s clear to any market practitioner that the current fee structuring actually benefits those who are less wealthy. And that’s a good thing because they’re the people who probably need the most help with costs and need market access.  Further, investors with more skin in the game generally pay higher fees because it’s worth more to them in absolute terms (more on this below).

Third, as Noah notes, larger portfolios generally get a substantial discount.Most asset managers have a sliding fee scale where larger investors actually pay a smaller relative % fee than smaller investors. So, if you’ve got $100MM to invest you might pay 0.5% relative to the $1MM investor who pays 1.5%.  Yes, you’re still paying a higher overall dollar cost, but the $100MM portfolio is more time consuming and expensive to manage.  Not to mention, it has a totally different regulatory burden. Plus, larger portfolios generally come with the burden of much higher expectations. Investors with more to lose have much higher expectations of their managers and are generally much more time consuming from a service perspective.

Fourth, when you hire an asset manager you’re really paying for their intellectual property. You’re hoping that you can leverage their expertise in some way that would result in better outcomes than you could otherwise do on your own. Noah is right that most mutual funds are just closet index funds with a negative value in their intellectual property, but that’s just a generalization about SOME asset managers.  So, an investor with $100MM has 100X more to lose than the $1MM investor if he/she hires someone whose intellectual property turns out to be of low value. In this regard, the AUM % fee structure aligns the interests of the investor and the asset manager.

This is no different than hiring a realtor. You pay a fixed $ fee because you think that realtor knows the market. The more expensive the market the more valuable the smart advice is in absolute terms. The same thinking goes for lots of service based industries. Bigger fish pay bigger fees because it’s worth more to them to pay the bigger fees. You pay more if you have more because you have more to lose.  It might not sound “fair” on a relative basis, but it actually makes a lot of sense when you think about it in absolute terms.

Of course, some “passive” indexing advocates would argue that there is no such thing as valuable intellectual property in asset management, but this is obviously nonsense because even passive indexers are ultimately actively picking their asset allocations for themselves or their clients. Since all forms of portfolio construction must necessarily involve some discretionary intervention then some asset pickers, MUST, by definition, offer greater value than others.  This is true even if, in the aggregate, all investors underperform “the market”.

Lastly, the AUM % fee structure is actually a very fair form of a performance based fee that helps align clients interests with manager interests. It’s not an explicit performance based fee like you might pay in an absurd 2& 20 style hedge fund, but an implicit one. That is, if the asset manager is charging flat fees then he/she really doesn’t care about portfolio performance. In fact, their portfolios can lose value every year, but as long as they’re gaining more clients their revenues are growing. This would be a massive conflict of interest. The asset manager only cares about client accumulation.  By charging a AUM % fee the investor and the manager’s interests are aligned. If the portfolio grows then the fees also grow. If the portfolio shrinks then the fees shrink.

I really struggled with this idea when I was starting my asset management business. I’ve actually utilized both structures at points over the last 10 years, but I ultimately decided that a very low AUM % fee structure made the most sense because it was less expensive than a flat fee for most investors who have less than $1MM (the vast majority of people), but didn’t sacrifice the need to align my interests with larger investors.  I think Noah should have written a piece about how investment fees are still too high rather than structured incorrectly. After all, that’s ultimately the larger problem. The fees in this business are just too high in my view.  But it’s not the pricing structure that’s wrong because the pricing structure makes the business model more workable than the alternatives.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering low fee asset management, private advisory, institutional consulting and educational services.Cullen is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
Cullen Roche

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