I really liked this article by Noah Smith at Bloomberg about why money managers get paid so much. The conclusion was basically: we don’t fully know why asset managers get paid so much and whether they get paid too much. I’ve spent A LOT of time thinking about this so I figured I might be able to shed some light on the issue.
My opinion is that asset managers generally get paid way too much. For instance, the average investment advisory fee is still close to 1%.¹ And the average equity mutual fund’s asset weighted expense ratio is 0.63% while the average index equity mutual fund costs 0.09%.² In other words, if you work with an investment advisor who uses active equity mutual funds you are paying about 1.6% per year and about 1.09% if the advisor uses index funds. For an investor with $1,000,000 this is the equivalent of dropping off a suitcase at your advisor’s office filled with $16,000 or $10,900 every single year. That’s an ungodly amount of money to pay someone just for managing your assets and it can have a devastating impact on your total returns. I doubt you pay your accountant, doctor, personal trainer or anyone else that much money in annual fees. So how do asset managers pull this off?
Salesmanship. The answer is salesmanship. I’ve been in this business long enough to know that asset management is mostly about selling the hope of superior returns in exchange for the guarantee of high fees. The problem for the average person is that they don’t actually know enough about the asset management business to quantify whether their investment manager is worth the fees they pay. And in fairness, a big part of that is due to the fact that you have to compare yourself to a counterfactual that doesn’t exist since paying 1.6% per year to invest in a crappy active mutual fund is probably a better result than sitting in cash all the time because you’re too scared to get fully invested. Investment managers, as expensive as they are, at least keep you in the game and you need to be in the game to score any goals.
That said, my view is that this business is massively shifting right now. Noah cited a paper referring to asset managers as “money doctors” because they earn their fees by proving to investors that they are a trustworthy steward of someone else’s assets. This is at least partly right, but I don’t love this idea. Of course, I think an asset manager has to be trustworthy. But asset mangers aren’t like doctors. They aren’t saving your portfolio. Instead, they are acting more like personal trainers. They are there to set-up an appropriate plan for you and maintain that plan for you through thick and thin. When you are feeling tempted to reach for the cookie jar it is the role of the asset manager to instill discipline in you and slap your hand away. After all, getting healthy is a lot like good investing – it is incredibly easy in theory and very difficult in reality because we are constantly getting barraged with emotional biases that tempt us to do things that are against our best interests. The asset manager instills discipline in you so that you don’t act against your own best interests. Not everyone needs this type of help, but in a sea of fake news and short-term temptation it can be difficult to remain disciplined.
The question of importance here is, what is this service actually worth? That’s a difficult question to answer. If you believe me that the investment management business is changing from one where people sell the hope of market beating returns to one where they sell appropriate and disciplined plans then the rush for the exits from high fee active funds will continue. And as people slowly realize that high fee market beating salesmanship is bunk and stop chasing the latest fads and high return managers they will realize that they shouldn’t overpay for having someone put together and maintain an appropriate plan. After all, there are a growing number of low cost services offering appropriate and disciplined financial plans without all the opaque high fee salesmanship. This includes Robo Advisors, fee only advisors and a truly incredible low cost service run by this handsome man named Cullen Roche.³
So, the answer to the question is rather simple in my view – investment managers make a lot of money because they take advantage of the biases of the average investor who wants to generate high returns. In exchange most of these investors get low returns thanks to the guarantee of high fees. And the remaining investors who still use a 1%+ advisor haven’t yet realized that there are plenty of low cost alternatives implementing similar quality strategies and services without the heavy price tag. But the high fee cat is out of the bag and it’s going to come under increasing scrutiny in the coming decades. In other words, money managers are about to start making a lot less money than they used to and that’s a good thing because it means that the clients get to keep that much more.
³ – Yep, I put my fees where my mouth is. At 0.2%-0.35% my asset management service is competitive with most Robo Advisors and significantly less expensive than the average investment advisor. The comment about being handsome is total bullshit though. I am probably a 6.5 out of 10 and getting worse by the day. 4
4-Full disclosure, Mr. Roche has a long-term short position in Mr. Roche’s future appearance. This position is protected in a non-revocable trust for the sole beneficiary, Mrs. Roche. She does not know that she is long this position and I would appreciate it if you kept this secret.