There seems to be a big hatred for high fund management fees, and this is something I both can and can’t get my head around. I put the word high in speech marks in the title because a high fee is, in my view, entirely subjective and as we all know, cheap doesn’t necessarily mean good, and good doesn’t necessarily mean cheap. “High” fees are subjective.
It is true that fund management has the ability to make healthy margins and profits, but then again, I don’t understand why profit is frowned upon. Google is allegedly free, but that business is massively profitable. Why is there not outrage that Microsoft made over $15bn profit last year – an increase of 1/3 over the last 12 months. Why aren’t these companies being pressured to reduce their charges? Why aren’t customers choosing alternative spread sheet or word processing documents in their droves?
Many will argue that the use of passive funds is the only alternative as the majority of active funds do not outperform and in this situation cheap is good. Trouble is, “outperform” is an incredibly subjective word. Outperform suggests – by default – there is something to compare against. In principle, investing is simple. Buy something and expect the value of it to rise. Ideally you’d like it to rise more than the average, but taken a little deeper, explaining investment performance is not really that simple when it comes to creating a comparison.
If you choose to go entirely down the passive route, what if the cheap index fund that has been bought doesn’t outperform? And doesn’t outperform what exactly? If you chose to invest 100% in the World equity index and the UK beats it, have you underperformed? Surely there is an active decision involved there. What if your time horizon is 10 years and the fund / index isn’t “delivering” (yet another subjective word) and you are only 7 years into your plan? What if the active fund you are investing in provides a yield 25% higher than the benchmark, are they comparable? Would you pay higher fees for this?
If an active fund provides exactly the same return as the passive fund over the same time period but achieves this with less price volatility, is that something you might pay more for?
There are possibly more indices than funds, and not all indices are replicated in unitised form, whether that be unit trust / OEIC or ETF for instance, so there is an argument that even though the potential choice is massive, the actual choice is limited.
Also remember, certain areas of investment just cannot be replicated in passive form due to the underlying investment; how do you decide what is an appropriate price to charge?
Many suggest active funds are poor value as on average they underperform. Active managers have the ability to perform and the differences they take to the index is the reason given for the potential to outperform. It is often argued that paying more for a greater degree of uncertainty relative to the index is a bad call when buying the index provides greater understanding. But how well do you know the index? The FTSE 100 for instance invests in 100 companies, but with more than 50% represented in the top 10 holdings, is there a concentration risk? When looking at these 100 stocks, is there comfort in knowing the split between the industrial classifications and how this has changed over time?
One way to align the interests of the fund manager and the client would be, in my view, to incorporate performance fees. To do this though, the fund should reduce its annual management fee which would assist should it underperform and if it can beat its reference index by more than x% over a defined period then why shouldn’t there be a bonus paid? In this regard, the fund outperforms, clients are rewarded with higher returns and fund managers are rewarded for the extra performance achieved.