It Costs How Much?

By Edward A. Studzinski

A democracy is a government in the hands of men of low birth, no property, and vulgar entitlements.


One of the responses I received to last month’s diatribe about mutual fund fees was that the average mutual fund investor did not object to them because they were unseen.  They painlessly and invisibly disappeared every quarter.  The person who pointed this out noted that lawyers charged a bill for services rendered, as did accountants.  Why then, should not a quarterly mutual fund statement show the gross amount invested at the beginning of the period, the investment appreciation or depreciation, and then the deduction of fees to arrive at a net amount invested at the end of the period ?  Not a bad idea.  But one that has been resisted (or gutted) at every turn by the industry and one that the regulators have never felt strongly enough to move forward on.

But do clients truly understand what they are giving up or what they are actually paying?  Charlie Ellis, in an article in the current issue of the Financial Analysts Journal would argue that they do not.  He goes on to make the case that the enormity of the fees as a percentage makes the 2% and 20 that many hedge funds charge seem reasonable in comparison.  His rationale is thus.  Assume an S&P 500 Index Fund achieves in a year a total return of 36% and charges investment management fees of 5 basis points (0.05%).  Assume your other investment is Mick the Bookie’s Select Investment Fund which had a total return of 41% over the same period and charges 85 basis points (0.85%).  Your incremental return is 500 basis points (5%) for which you paid an extra 80 basis points (0.80%).  Ellis would argue, and I believe correctly so, that your incremental fee for achieving that excess return was SIXTEEN PER CENT.  And don’t forget that the money that went into the account to begin with was already your money that you had earned.

So, one question that I hear coming is – the outside trustees or directors have to approve fees annually and they wouldn’t do it if it was not fair and reasonable, especially given the returns.  Answer #1 – eighty per cent of the time the active manager does not beat the benchmark and achieve an excess return.  Answer #2 – the 20% of the time when the active manager beats the return, it is not on a sustainable basis, but rather almost random.  Answer #3 – rarely does the investor actually get a benchmark beating return because he or she moves their investments too frequently to even achieve the performance numbers advertised by the investment management firm.  Answer #4 – all too rarely do the outside trustees or directors have an aligned vested interest in the fee question  (a) because in most instances they have at best a de minimis investment in the fund or funds that they are overseeing and (b) oddly enough the outside trustees or directors often have more of a vested interest in the success of the investment management company.  Growth and profitability there will lead to increases in their fees.

So you say, I must be getting something of value for the incremental fees at those times when the investment returns don’t justify the added expense?  Well, sadly, if recent history is any guide, the kinds of things you have gotten for such excess incremental fees include things like vicarious interests in yachts and sports cars; race horses in Lexington, Kentucky; and multiple homes and pent houses on the lake front in the greater Chicago area.  I could go on and on in a similar vein.  Rather than outperforming benchmarks or making money for investors, the primary goal has morphed to the creation and accumulation of substantial personal wealth, often to the tune of hundreds of millions of dollars.

To paraphrase Don Corleone in that scene in New York City where he says to the heads of the Five Families, “How did we let things go so far?”  I don’t have a good answer for that.  I suspect that the painlessness of fee extraction explains part of it.  Having had the present administration in Washington serving in the role of defender of Middle Class America, one has to wonder why they have allowed the savings and investments of the Middle Class to effectively be clipped by dollars and cents every month.  What has happened is one of the great hidden wealth transfers in our society, similar to what happens  when hackers get into a bank computer and start skimming fractions of cents from millions of transactions.  It is not solely the administration’s fault however, as neither the regulators nor the courts have wanted to clean up the fee mess.  Everyone really wants to believe that there is a Santa Claus, or more appropriately, a Horatio Alger ending to the story.

One might hope that financial publications such as Morningstar, would through their media outlets as well as their conferences, address the subject of fees and their excessive nature.  Certainly when they  first started with their primary conference at the Grand Hyatt at Illinois Center in Chicago, there was a decided tilt to the content and substance that favored and indeed championed the small investor.   However, since then in terms of content the current big Morningstar conference here has taken on more of an industry tilt or bias.

Why do I keep harping on this subject?  For this reason – mutual fund investors cannot negotiate their own fees.  Institutional investors can, and corporate and endowment investors do just that, every day.  And often, their fee agreements with the investment manager will have a “most favored nation” clause, which means if someone else in the institutional world with a similar amount of assets negotiates a lower fee agreement with that investment firm the existing clients get the benefit of it.  If you sit in enough presentations from fund managers, it becomes obvious that, public industry statements notwithstanding, in many instances the mutual fund business (and the small investor) is being used as the cash cow that subsidizes the institutional business.

Remember, expenses matter as they lessen the compounding ability of your investment.  That in turn keeps the investment from growing as much as it should have over a period of time.  With interest rates and tax rates where they are, it is hard enough to compound at a required rate to meet future accumulation targets without having even further degradation occur from the impact of high fees.  Rule Number One of investing is “Don’t lose money” and Rule Number Two is “Don’t forget Rule Number One.”   However, Rule Number Three is “Keep the expenses low to maximize the compounding effect.”

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.