What does active management cost? Answers will vary depending on the ferocity of the respondent’s belief in passive investing.
Some will simply highlight the difference in expense ratios between an actively managed fund and a passive equivalent. Others will stress the compounding opportunity cost of underperformance that can come from active managers.
It was presumably this latter mentality that informed Warren Buffett’s letter to Berkshire Hathaway shareholders earlier this year. ‘My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade,’ he wrote.
‘Figure it out: even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds 10 years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative.’
Indeed, a new study suggests that Buffett may have understated the cost. Rather than his annualized $10 billion, it claims that the public is overcharged for active management by around $30 billion each year.
That figure comes from Florida State University professor Stewart Brown and independent financial consultant Steven Pomerantz, who examined 10 years of recent fund data.
Their investigation begins with some apparently good news. Between 2005 and 2015, assets under management in active funds – excluding index and money-market products – more than doubled from about $4.6 trillion to $9.5 trillion. However, active’s share of the entire mutual-fund industry slipped from 73% to 68% as investors switched to passive options.
As would be rationally expected amid this competition, the asset-weighted average expense ratio of the active funds fell from 0.95% to 0.8% over this period.
That may seem encouraging at first glance, but Brown and Pomerantz dug even deeper. Expense ratios consist of three distinct elements: administrative fees, distribution or marketing fees, and management or advisory fees. Cynics will already have guessed that the 15 basis point reduction in expense ratios did not come from the managers’ cut.
Over the 10-year period, asset-weighted average administrative fees declined by almost a third from 0.21% to 0.15%, as would be hoped given the economies of scale, with active assets having doubled in size and asset-weighted average distribution fees having almost halved from 0.21% to 0.12%. However, the fall in these 12b-1 charges was only due to the fact that the proportion of assets in active funds that imposed them dropped from 56.4% to 39.8%. In dollar terms they still climbed from $9.8 billion in 2005 to $11.1 billion in 2015.
Meanwhile, asset-weighted average management fees actually increased slightly over this period, from 53 basis points to 53.2 basis points. The median management fee rose by even more, from 77 basis points to 84 basis points, implying a long tail of smaller, more expensive funds.
‘These results are inconsistent with the competitive pricing of advisory fees,’ Brown and Pomerantz said. ‘The median fee increase indicates that new funds and the entry of new fund sponsors occurred at higher prices. New entry and competitive pricing would normally result in lower overall prices.’
The $30 billion question
So how do they arrive at their headline $30 billion? As with so much in investment management, Vanguard is the key.
Brown and Pomerantz contrast the fees negotiated by Vanguard for its subadvised active funds with costs elsewhere in the industry. Vanguard’s asset-weighted average advisory fees are 10.7 basis points – a fraction of the average 45 basis points for the other nine groups that make up the 10 largest active managers in the US. If firms are willing to provide active management to Vanguard that cheaply, why can’t they do so for other investors?
‘It follows that on average the top nine fund families are overcharging their clients by about 34.3 basis points – 45 minus 10.7 – on an annual basis,’ Brown and Pomerantz argued. ‘Applying the 34.3 basis point estimate to the total of non-Vanguard actively managed open-end fund assets of $8.86 trillion yields an estimate of $30.4 billion annually.’ They reached a similar number when coming at the question from other angles too.
Brown and Pomerantz concluded with a quotation from an American Nobel laureate. ‘I decided there was only one place to make money in the mutual-fund business. As there is only one place for a temperate man to be in a saloon, behind the bar and not in front of the bar, so I invested in a mutual-fund management company,’ Paul Samuelson told Congress in 1967.