This past Saturday was not unlike most of my recent Saturdays. I woke up around 7:30, fed my  seemingly perpetually starving Siamese cats, and contemplated the end of what was yet another *fabulous* infrastructure week here in the good ole U.S. of A, all before heading out to stress shop. 

I’ve always said that shopping is my main form of cardio, but you may not know it’s also one of my favorite methods of stress management, too.  There’s something about a perfectly climate-controlled dressing room, a commission-based sales rep at my beck and call, and an impeccable frock (or purse, pair of shoes or new iPhone for that matter) that makes everything bad in one’s life feel more like a distant land war in Asia, rather than like a bar fight in your living room.

This weekend, as I was trying on my potential retail spoils, I happened to overhear a conversation in the dressing room adjacent to mine. A mom and a daughter were discussing a sweater, and whether it could be purchased for less money at another store. The objectionable price of said sweater? $30. 

Yep you heard me (read me?) – thirty whole American dollars.

My first thought was “You can buy a sweater for 30 bucks?!?”

I mean, I was at the Nordstrom Rack (I may be seriously into retail therapy, but most of the time I see no reason to pay full price for it), but I can’t recall the last time my hands have alighted on a $30 anything, much less knitted goods.

My second thought was “Would you really want to wear a sweater that could be purchased new for $30? What would said sweater be made of? What would this sweater look like? Would this sweater hold up to normal use without starting to resemble Rachel McAdams’s shirts in “Mean Girls?”  

 (C) Morguefile.com

(C) Morguefile.com

I was really struck by two things in the aftermath of the sweater discussion: First, what a privilege it is not to have to worry about spending $30 on a sweater. But second, and more important, how a lot of us have pretty much started to expect everything to be cheap. 

Especially when it comes to the investment world.

It’s true that there has been a colossal amount of fee pressure and compression in the investing world over, say, the last 10 to 20 years. For example, active equity mutual funds charged an average of 1.08 percent in 1996, but a mere 0.82 percent by 2016, and equity index funds saw fees plunge from 0.27 percent to 0.09 percent over the same period.[1]And of course, Fidelity upped the low-cost ante even further this year when they announced two no-fee index funds (Tickers: FZROX and FZILX), attracting more than $1 billion in their first month.[2]

One of the investing groups to get the biggest full-court (fullest court?) fee press is hedge funds. In fact, a mid-September Institutional Investor article touted that hedge fund fees had fallen to record levels, with management fees near 1.43% and incentive fees hovering around 17%.(3) Of course, this massive “decline” assumes that hedge fund fees peaked, as often advertised, at 2% and 20%, which I have loudly and repeatedly asserted for years that they didn’t, based in no small part to research that I did in 2010. 

This research showed that, at the height of hedge funds’ popularity, and based on a sample of more than 8,000 funds, management fees for funds that launched in 2009 averaged 1.65%, up from 1.35% for 2000 vintage year funds. Likewise, incentive fees during the period were largely stable. They clocked in at 18.7% for vintage year 2000 funds and dropped to 18.5% for hedge funds launched in 2009. So, while there has been a decline in average headline fees (the fees charged per Offering Documents, not negotiated for large investors, longer-lockups or founders’ shares), it hasn’t been a dramatic as one may think. 

But the bigger question that many have asked is “how low can fees go?” And that, much like my $30 sweater conundrum, is an excellent question.

The rise of index tracking, low-cost ETFs, and the decade of stellar performance of the same, has led some investors to believe all returns should come cheap. But even leaving aside market cyclicality and the active/passive debate, there’s a pretty big difference between mammoth firms like Fidelity or Vanguard offering funds for three basis points and a $100 million hedge fund, private equity / venture fund or even most long-only active managers offering the same. 

Why? 

The primary issue is economies of scale – Vanguard managed $5.1 trillion (with a “T”) as of January 2018. Blackrock managed $6.317 trillion (again, with a “T”) as of March 2018. Fidelity managed $2.45 capital T trillion as of the end of 2017. If Fidelity charges an average of three bps on its assets under management, it still generates a helluva lot (with an “H”) in fee income. 

If Jo Schmoe Fund does the same while managing $100 million, they spit out a paltry $300,000 in revenue. Even if Jo earns a hefty return on investment, triggering the payment of an incentive allocation, that still may not be big enough dollars to run an institutional quality business. 

Even if JS Capital Management manages to grow assets to ONE BIIILLEON DOLLARS, they might be able to buy a metric crapton of $30 sweaters charging 3 bps, but running a legit asset management business? I wouldn’t always count on it. Sure, they’d rake in $20 million on a 10% performance year (assuming a 20% incentive allocation), but not every year turns out that way. 

There are some years, thought we may not remember them well, where it would be considered outstanding performance to be flat. There are some years when a strategy just isn’t in favor. There are some years when stuff just doesn’t go your way. Do you want to incentivize a manager to use excess leverage, to under hire, to spend all their time trying to raise additional assets so they make a decent buck, or to take undue risks with your capital?

I’m not sure I do. Which is why I didn’t pop my head out of the dressing room to snatch up the mysteriously alluring, though inexpensive $30 sweater on Saturday. The risks of contact dermatitis, catastrophic sweater failure and potential public ridicule were just too great. 

 

 

[1]https://www.ici.org/pdf/per23-03.pdf

[2]https://www.cnbc.com/2018/09/04/fidelity-offers-first-ever-free-index-funds-and-1-billion-follows.html

https://www.institutionalinvestor.com/article/b1b0wqn4k95f20/After-Years-of-Cutting-Fees-Hedge-Funds-Say-Enough-is-Enough

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AuthorMeredith Jones