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Fees Are Your Foe

Charles D. Ellis

THE COSTS WE PAY for active investment management are important—far more important than most investors seem to realize, particularly when the stock market is going up and up.

Start with an interesting reality: Nobody ever actually pays such fees by writing a check. Graciously, money managers take care of that, deducting their fees from the assets they manage for us. Out of sight, out of mind. But wait: Perhaps, instead of being grateful, we should be careful to understand what’s going on.

Money managers and investment advisors will say fees are “only 1%.” True, that might seem low if you look at it the conventional way. But isn’t this misleading? Is there a better way?

For example, why are fees based on assets? Years ago, major law firms—which crafted trusts for their clients—also charged by the hour to manage investments, the same way they billed for creating the trusts. But firms that specialized in investing then decided they should charge more for managing larger trusts, and based their fees on a percent of dividends.

Following the Great Crash of 1929, portfolio assets dropped more than dividends were cut. In response to client complaints, leading firms changed their fee formula. They based fees half on dividends and half on assets. That practice was later simplified to basing fees on assets alone. Still, fees were quite low, typically 0.1%.

Without telling clients, managers found a way to do better for themselves. With brokerage commissions fixed at about 40 cents a share, bank trust departments—then the dominant investment managers—made deals with brokers. In exchange for banks paying commissions, brokers deposited large sums of customer money at the banks. Banks, in turn, could lend out that money to corporate and other borrowers. The interest income on these loans was credited to the trust departments.

This quiet arrangement worked well until brokerage commissions were made negotiable in 1975. To keep the trust business profitable, something had to change. That’s when the nation’s leading trust company, Morgan Guaranty Trust, increased its management fees to 0.25%. Contrary to the expectation that it would lose many accounts, it lost just one.

The investment management industry realized that fees didn’t matter to clients.

Of course, this was nearly half a century ago. Back then, most clients believed the “better” managers would “beat the market,” so wise investors would pay up to get better results. The comprehensive data on returns that we now have wasn’t then available, so this belief wasn’t challenged by evidence.

The idea that higher prices are indicative of “better” value was documented by sociologist Thorstein Veblen. He found that high prices for luxury goods could actually increase sales, contrary to the law of supply and demand. This “Veblen effect” can still be seen in luxury markets, such as those for fine wines, high-end watches, and top-of-the-line dresses, suits, handbags and shoes.

But do investors actually get greater value—meaning higher returns—when they pay higher fees? The objective data is clear: no.

SPIVA data on stock mutual funds is particularly damning: 86% of U.S. actively managed stock mutual funds failed to keep up with the broad market over the 10 years through June 30. On top of that, those that fell short failed by a far larger margin than the benefit that accrued to those lucky few who beat the broad market.

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While there may be a few funds that outpace their benchmark, any statistician who studies the data would throw cold water on the hopes of finding a winner going forward. The odds are high that, among the 14% that did better over the past 10 years, the vast majority will do worse over the next 10 years—and there’s no known way to identify which funds will be the exception.

Investors shouldn’t let their judgment be swayed by the Veblen effect, and instead should take another look at the question of fees, especially when they’re couched as “only 1%.” They may be surprised at how high active management fees really are—when framed in other ways:

  • Suppose we frame fees on expected returns instead of assets. If long-term returns average 7%, then fees posted as “only 1%” are actually consuming 14% of expected returns. This vaporizes the word “only.”
  • All active managers must purport to be “different” than the overall market in some way. Adjusting fees to reflect this greater risk would lift fees at least a bit higher.
  • While rarely discussed, taxes on actively managed funds are much higher than on index funds. Active managers trade much more frequently than index managers, and so realize taxable gains for shareholders.
  • Another cost of using active managers is actually imposed by investors on themselves, but it’s nonetheless real. That’s the cost clients create by changing active managers at the wrong time or by going to cash when the market declines.
  • Finally, another “cost” is the worrying that clients do. They fret that they’ve chosen the wrong manager, and wonder what they should do about it and when.

These subtle costs add up. Investors—not you, not me, but the guy behind that tree—might lose 20% to 30% of what they could have earned in any given year. Compounded over the long term, these costs add up and up.

Fortunately, today’s investors have an alternative: low-cost indexing. This matter of fees is not “just an academic question.” The effect of high fees on investments can be objectively measured—and, thank goodness, overcome.

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HERE ARE THE SIX other articles published by HumbleDollar this week:

  • “I wasn’t in a strong enough position to invest in a failure—and we suffered two,” writes Richard Hayman. “I went from feeling good about not running out of money to being extremely worried.”
  • Don’t chase performance. Beware company stock. Favor target funds. Avoid naive diversification. Consider index funds. Resist home bias. John Lim offers six principles for 401(k) investors.
  • “When it comes time for me to kick the bucket, I want to make sure it’s a big bucket I’m kicking,” writes Jim Kerr. “And that it has plenty of dents from all the places we’ve gone together.”
  • Transparency. Predictability. Equity. Adam Grossman discusses three principles that should guide parents’ financial gifts to their adult children.
  • “Representing Social Security as theft, a rip-off or a Ponzi scheme is reprehensible,” argues Dick Quinn. “That’s like saying term insurance is a rip-off if you don’t die within the insured period.”
  • Want to change careers or lead an entirely different sort of life? Take a cue from millennials, advises Jim Wasserman, and don’t let yourself be held back by traditional measures of success.

Also be sure to check out the past week’s blog posts, including Mike Flack on Medigap policies, Jiab Wasserman on elder abuse, Dick Quinn on IRMAA, Kyle McIntosh on hybrid cars and Howard Rohleder on his retirement number.

Charles D. Ellis is the author of 18 books, including Winning the Loser’s Game, which is now in its 8th edition, with 600,000 copies sold. Charley has taught investing courses at both Yale and Harvard business schools, and he served for 17 years on Yale’s investment committee. Check out his earlier articles.

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betsy larey
betsy larey
16 days ago

I am with Mairs and Power private investment group. I pay 60 basis pts on the first M and 40 thereafter. I consider that a very reasonable amount. I own individual stocks, and do not get hit with gains from funds. It’s the most tax efficient way to invest. I like having someone I trust to bounce things off of. I don’t like funds because of the tax consequences. It works for me.

Jack Hannam
Jack Hannam
16 days ago

(1.10 X 0.99)^50= 71.02
(1.10)^50=117.39

Jack Hannam
Jack Hannam
16 days ago

When I disclose that I do not use an advisor, I think of the case where a group of people are asked whether they consider themselves to be above or below average drivers, and a large majority say they are above average. I hope I’m not deceiving myself. I know of family and friends who are better off getting advice, provided they know what they are getting and how much it is costing them. I will defer to experts like Prof. Ellis, (I have read a few of your books) and Jonathan on more precise calculations, but one which illuminates the cost for me is: Assume a lump sum is invested for 50 years, earns 10% per year, and ignore inflation and taxes. The gain is 117 fold. Same investment but with a fee of 1% of assets produces a gain of 71. The investor paying the fee with an identical investment ended up with 61% as much.

SanLouisKid
SanLouisKid
17 days ago

From the Vanguard website: Core purpose To take a stand for all investors, to treat them fairly, and to give them the best chance for investment success // Also from the Vanguard website: Total assets About $7.2 trillion in global assets under management, as of January 31, 2021. // I think people are starting to get the message.

Last edited 17 days ago by SanLouisKid
Andrew Forsythe
Andrew Forsythe
17 days ago

Thanks for this, Charles. This sentence caught my attention and really brings it home:

If long-term returns average 7%, then fees posted as “only 1%” are actually consuming 14% of expected returns. 

mytimetotravel
mytimetotravel
17 days ago

I recently calculated that if I had been paying a 1% AUM for the twenty years since I took early retirement I would be out getting on for $250,000, and that doesn’t include the lost compounding. Instead I am almost entirely in Vanguard index finds and my annual fees are around .18%. Every few years I pay a fee-for-service financial planner to review my plan and investments. I did that this year. It cost me $1,250, paid to a CFP operating as a fiduciary. (I am on track, with a Plan B if inflation stays at 5%.)

mytimetotravel
mytimetotravel
17 days ago
Reply to  mytimetotravel

That should be funds, not finds, of course. This site doesn’t seem to have an edit function. Although I suppose you might call Vanguard index funds finds for DIY investors.

SanLouisKid
SanLouisKid
17 days ago
Reply to  mytimetotravel

Actually, this site does have an edit function. It’s a little “wheel” that shows up on the bottom right of the post, but you have to hold/wave your cursor around a little to make it appear. Not ideal, but it does work.

Kevin Lynch
Kevin Lynch
17 days ago

The article estimates that 20-30% of investment returns are lost via an investment advisor. I think that percentage may be much higher. A 7% investment return is reduced by taxes (assume 1%) and inflation (assume 2%) resulting in a 4% real return. The investment industry has the advisor taking 1% and its typical for them to put clients in their firm’s overpriced mutual funds charging at least an additional 1%. The net result is that the advising firm takes ONE-HALF the real returns for putting clients in investments inferior to INDEX FUNDS. One word sums up the financial advising industry – GREEDY.

Guest
Guest
17 days ago

Now will you write a column about real estate commissions.
In this reader’s opinion, that’s far worse.

Rick Connor
Rick Connor
17 days ago

Good article Charles. I’d be interested in knowing how you think Financial planners and RIAs should structure their costs?

Ormode
Ormode
17 days ago

If you manage your own portfolio, you’ll find out what you’re paying for. You can spend all day reading corporate financial statements, conference calls, and articles in trade publications. What is your time worth? Do you enjoy analyzing and evaluating companies?

mytimetotravel
mytimetotravel
17 days ago
Reply to  Ormode

Nonsense. With broad index funds that is entirely unnecessary. I occasionally review my asset allocation, I occasionally rebalance, every few years I have a professional review my plan. I haven’t analyzed a company since a very brief spell in an investment club years ago. And yet my portfolio has been quietly growing.

Newsboy
Newsboy
17 days ago

Great article, Charles – framing an annual fund management fee as a percentage against expected annual return of a fund an is a nice exercise in contrast to the “just 1%” mantra…and a very enlightening exercise!

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