The Costs of Active Management

The Turnkey PhD and I were talking this afternoon about how egregious fees can get in the active money management business, with managers routinely charging 1-1.5% for assets under management, plus a performance fee of 20% of profits above $0.  And this occurs in a world where the majority of active equity managers underperform benchmark indexes and “long/short” means “long-focused, with an occasional short when things feel shaky in the economy.”  It is strange how in light of this evidence, people continue to pay these outlandish performance fees in the hope that they will beat the market.

Of course, we aren’t the only folks discussing fees:

• Here are some of Mebane Faber’s thoughts
• Dealbreaker on a tyrade
• Wall Street Journal with their 2 cents
• Barry Ritholtz has some good advice on managers: one major bullet point, avoid ‘excess fees funds’
• and so on and so on…

The Turnkey PhD sent me an academic piece written by Ken French that really took my breath away.  In it, French describes an analysis on the impact on returns of fees, expenses and trading costs associated with the active management process versus a passive investment approach.  The results are staggering, but let me provide some background first.

French begins with the assumption that there is no net transfer between the passive market portfolio and active managers.  That is to say, a trading gain for an active investor must be an equivalent loss for another active investor.  It therefore follows that a switch from passive to active management involves a premium that is the difference between the costs to manage actively and the costs to manage passively.  French is a charitable guy, so he admits that the active managers do provide society with some value, in that they enhance the price discovery process.  That’s very big of him.  But back to the active management premium: just how big is this premium?

Let’s take 6.7% as a reasonable long run average annual real return for the stock market.  It turns out that, according to French’s analysis, investors spend 0.67% per year for active management services.  This implies that the capitalized cost of price discovery, which is the economic value of what society receives from active managers, is about 10% of the current value of the market.  In case you were somehow feeling good about this outcome, he then mentions some research suggesting that expected real market returns may be substantially below 6.7% (i.e., if the real return is more like 4%, we are capitalized price discovery costs north of 16%).

As I read through the analysis, I kept wondering about taxes.  As I mentioned earlier, French is a charitable man.  He had the following to say about taxes: “…to a taxable investor choosing between active and passive strategies, the extra tax burden that typically accompanies active trading is a cost.  From society’s perspective, however, extra taxes are just a transfer, so I do not include them in my estimate of the resources society spends to beat the market.”

Okay, so from a societal perspective, I understand where he is coming from.  But from the perspective of an individual investor, this is an entirely new layer of costs associated with active management.  Active portfolios turn over much more frequently than passive portfolios, and also often generate tax-disadvantaged short term gains.  If you are in an actively managed fund, chances are good that you are paying hefty and unnecessary tax bills every year for the privilege.  Perhaps some other well-known academic could explore this question of the impact of active managers on collective tax bills.

Regardless, how can it be reasonable in any sane universe for managers, who in the aggregate cannot beat the indexes, to provide a 10% or greater haircut to investors, and then, in most cases generate huge tax bills? What possible rationale is there?  It makes no sense, and it seems like the money management system could really use a fundamental restructuring that would free up resources for more productive uses for society.  The Turnkey PhD suggested that in 100 years people will look back and be dumbfounded by the fees associated with our active management process today.  I hope that is true, but I’m not convinced: behavioral biases and greed run deep in the human condition.