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2 & 20 is Dead – 1 & 15 is on the Way Out….

The recent uproar over high fees is not a mere fad.  I think it’s here to stay and I think it’s going to get much worse for high fee financial firms who don’t adapt.  The problem is multi-faceted, but there are two huge headwinds coming for the high fee financial firms:

  1. Technological innovations
  2. A world of low returns

The first one is in our face every day.  You not only have enormous tech efficiencies in the way traditional advisors operate and the way markets operate, which reduces costs across the board, but you also have the robo-advisors and more automated services coming online which are driving costs down across the board.   This means that almost anyone can get reasonably good financial advice for 0.5% or lower.  And that figure could be on the high side as the years go by.

Further, we’re entering a world of low returns.  The share of outstanding public stocks has been reduced substantially relative to bonds over the last 30 years as interest rates have declined and it’s become more cost effective for firms to finance themselves via debt issuance.  And at the same time interest rates have been driven to zero by zero interest rate policy and weak economic conditions.  This combination means that the future returns on asset classes are likely to look nothing like they have in the past – particularly for the slice of asset holders who don’t own that reduced slice of the equity pie.  This means returns are likely to be lower which means that asset managers are going to be competing in an environment that is increasingly competitive for a reduced amount of return.  And as more and more investors realize that the high fee managers are cutting further into their returns than they did in the past they are likely to look for lower cost alternatives.

The uproar over 2 & 20 is just getting started.  Next we’ll hear about 1 & 15 and then 1 & 10 and eventually we’ll start hearing about hedge funds whose fee structures resemble traditional mutual funds (many of which are already on their death beds).  But the bottom line is, this isn’t the end of the decline in overall fees.  And that’s a great thing for investors.

4 comments
  1. Avatar
    Frederick

    The fad is “hedge funds”. I liked the chart in your book showing how none of them even hedge any more.

  2. Avatar
    Deal Arb

    How do you achieve a Sharpe Ratio in excess of 2 without hedging? I realize 80% of hedge funds have become as middling as mutual funds, and are taking dumber bets in this low interest rate + crowded alternatives regime, but there are a few disciplined managers out there. In my merger arbitrage book, my short exposure is 38% of my long exposure. And my Sharpe trades around 3, inclusive of 2008.

  3. Avatar
    jswede

    I’m surprised you speak of HF’s as though they are all alike, and an asset class. Just bc for every REAL HF there are 20 “wanna-be’s”, doesn’t mean Bridgewater is going to cut fees.

    It will always seems silly and expensive to hedge, until you really need(ed) it. Real, consistent risk-adjusted returns will never go out of style and the top funds will always be able to charge for it.

  4. Avatar
    John Daschbach

    Cullen, you get some of the reasons, but don’t follow through on your thinking.

    “The share of outstanding public stocks has been reduced substantially relative to bonds over the last 30 years as interest rates have declined and it’s become more cost effective for firms to finance themselves via debt issuance.”

    This is true. But look at some of the primary factors involved. Debt holds the high card in our economic system. In bankruptcy, it is debt holders who divide the all assets when asset market value is lower than nominal debt outstanding. Equity holders get close to zero.

    Second, the government has often bailed out debt holders, as in the recent economic downturn, but in general not equity holders (GM might be an exception). Lot’s of people talk about the bail out of “Wall Street Banks” and the great profits they are now generating. But the equity holders in companies like BA took a huge hit and have never recovered.

    So, in the current system, debt holders have a huge advantage over equity holders, both through our long established contract law, and through the bailouts of debt holders by taxpayers. Granted, unrealized equity returns are high now, relative to the post-crisis low, but it’s clear that wealth preservation is highly biased towards debt holders.

    People who hire asset managers are concerned with wealth preservation, and in a world where that is almost structurally codified in debt instruments (which for the most part only require a $15 Business Calculator to figure out) fees for asset managers should fall a great deal.

    You pay people to handle complex things you don’t have the ability or time to understand. If debt instruments are the clear path to wealth preservation in the face of uncertainty, then you don’t need asset managers.

    But I would not be too worried. The savings world will return to recognizing equity as a valuable primary option and skilled asset managers will do well.

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