Where Are The Clients’ Yachts?

In most things we buy, we can see a clear connection between price and quality. We appropriately expect a $2,000 suit to look better longer than a $200 one. We should assume a $500 per night hotel has more amenities than a $100 one. The prices of these items are clear and allow us to individually make an informed decision between quality and cost. But the next time you are shopping for

a new clothing item, what if the prices aren’t clearly marked? Worse yet, after you’ve bought an expensive suit, what if your expectation didn’t become reality and it began to fall apart after just two cleanings? Would you pay the premium for the more costly one the next time around?

In the investment industry, many investors and advisors have been confused into believing that higher investment manager fees are likely to generate higher returns, even after they’ve experienced repeated disappointments. Let’s see why so many people hold this belief and what you can do to give yourself a better investment experience:

A Few Definitions

When we reference “investment managers,” we are referring to firms whose sole function is to select the individual securities (stocks, bonds, etc.) according to a defined strategy, either for a pooled vehicle like a mutual fund/hedge fund or for separate client accounts managed according to a similar strategy. “Investment advisors,” in contrast, provide a much broader range of services, including assisting clients in assessing their goals and risk tolerance, determining the appropriate asset allocation, and recommending the investment managers to be used in each client’s portfolio.

“Passive” investment managers are those who have no opinion about either the future direction of the market, or the relative attractiveness of specific securities. They typically invest in a broad group of securities intended to track the performance of the market or a specific segment of the market (small stocks, emerging markets stocks, etc.). “Active” investment managers, on the other hand, try to identify the specific securities that they believe will outperform the market and only buy these securities in the portfolios they manage.

The Facts

Most investment managers are “active” managers, paid to do one thing: Produce above-average returns. Unlike many investment advisors, who should offer advice and personal consultation to their clients, investment managers generally provide the same products to all clients and in most cases don’t know anything about the investor whose money they are actually investing. In the case of most investment managers, the product they are selling is intended to beat “the market,” that is, to produce a higher return than that of the particular segment of the market (large U.S. stocks, global bonds, emerging markets stocks, etc.) in which they invest.

Investment managers can be costly. According to a recent study by Vanguard, the average cost of mutual funds that invest in large U.S. stocks is 1.12% a year1. Some might view this as “only” paying slightly over 1%, but the investor is not paying this fee to acquire the assets that he’s investing; he already owns them. Rather, he is paying the fee solely for the prospect of future growth. If the stocks held by the fund produce a pre-fee return of 10%, the annual fee paid to the fund represents over 1/10th of that growth. What makes the magnitude of these fees even more significant is the fact that investors don’t need to pay fees of this size simply to capture the returns of the market; they can do so with lower-cost passive “index” funds, of which some readily-accessible ones are priced as low as only 0.05% annually2.

In aggregate, active investing underperforms passive strategies that own the entire market. After fees, investors in “actively-managed” strategies lose money in aggregate relative to the market. This is because of the simple arithmetic that all active investors are competing against each other. In general, every stock that one active investor sells must be bought by a different active investor; thus, the aggregate outperformance of the “winning” active investors over the market’s returns will precisely equal the aggregate underperformance of the “losing” active investors, before fees. But, it’s important to remember that all active investors are generally paying higher fees to play the game than if they invested in passive strategies that simply bought and held a portfolio that looks like the market. Thus, the marketplace of these active investors resembles wagering on a coin flip at a casino: The sum of all the players’ excess returns will be zero before “the house” takes its cut. More specifically,the total aggregate return of all active investors will equal the “market return,” less the fees the active investors paid.

If Paying High Fees Is So Illogical, Why Do Investors Do It?

Lack of awareness. The costs of investing are unfortunately often opaque to investors. Investors in a mutual fund don’t get a bill or write a check for their investment management fees; they are paid directly out of the fund. While information is published about each fund’s costs, it is often buried in hundreds of pages of regulatory disclosures that many investors simply don’t have the desire to read. As a result, investing becomes one of the few areas in life where the average person often doesn’t even ask the price before buying.

Overconfidence in distinguishing skill from luck. Even if an investor understands the reality that not all active investors can be above average, they might believe that by “trying harder” or “being smarter” than their actively-investing peers, they or the managers they select can earn a persistent premium over the market. Effort and intelligence are valuable traits, and might have generated a sustainable edge for some small group of investors decades ago, but the sheer number of participants in today’s markets, not to mention the speed of information flow around the globe, should make us skeptical that a particular manager’s past results are truly from repeatable skill, not just luck. This belief is supported by a number of studies that show the past performance of most active managers has virtually zero predictive power. A paper co-authored by Nobel-prize winner Eugene Fama analyzed actively-managed U.S. equity mutual funds over their entire lifetimes and concluded that the proportion demonstrating skill was equal to that which statisticians would expect simply by chance3. Put in plain English, this means that if you put 1,000 monkeys in a room and had them throw darts at the Wall Street Journal to pick stocks, the results would look roughly like what we observe in reality from active managers: The majority hover around the market average, a few do very poorly and a few do very well. But would you pay the monkey who outperformed in the dart-throwing exercise a premium fee under the premise that they will repeat their past success? This is effectively what many people are doing when they hire an active manager with an enticing short-term track record.

Industry advertising and marketing. The lack of awareness of the “arithmetic of active investing” and the overconfidence of investors described above have undoubtedly been fueled by the massive marketing resources of the active management investing community. These firms have a vested interest in confusing investors into believing that random outperformance is actually a repeatable skill that justifies higher fees. They promote, and the financial media fawns upon, funds and managers that have outperformed over the past three- or five-year period. After you invest and the fund doesn’t repeat its past results, there’s plenty of new messaging to entice you to switch to a different fund that now sports a good past track record. As

the saying goes, “insanity is doing the same thing over and over again and expecting different results.”

What Can You Do?

Be aware of the importance of fees. Understand that, unlike the direction of the markets or the performance of a particular active manager, investment costs are controllable. Not only are they controllable, but they can have a material impact on your wealth. Nobel-prize winner William Sharpe, in his paper entitled “The Arithmetic of Investment Expenses” used simulations to reach the conclusion that if an investor chose low-cost funds over high-cost funds, on average they would have a 20% higher standard of living in their 30 years of retirement4!

Demand transparency. If you work with an investment advisor, be critical of those who don’t openly discuss the fees of the underlying investment managers that they recommend, and how they incorporate fee analysis into their decision-making. If you invest on your own, make sure fees are part of your evaluation criteria when selecting mutual funds or investment managers.

Be skeptical of the “rear view mirror” value proposition. Many investment advisors entice clients with the apparent sophistication of their investment manager selection process and the attractive three- or five-year track records of the managers they currently recommend. But, as we’ve discussed, studies have shown those track records to be virtually irrelevant in predicting future performance. Why didn’t your advisor recommend that manager to you years ago, before the good performance occurred? Advisors can add value in lots of repeatable ways, such as behavioral coaching, effective tax management and your keeping your wealth aligned with your goals. But if the only thing your advisor is offering you is his supposed “skill” at picking good investment managers, look elsewhere.

As humans, we are often distracted into fearing items and events that are relatively rare, while ignoring things that might be truly damaging. We fear sharks and terrorists more than heart disease and cancer, despite the fact that we are over 35,000 times more likely to die of heart disease than terrorism5. We fear the dramatic events because they capture our attention. Likewise, as investors it’s easy to be attracted to claims of protection against market crashes or “high returns with low risk,” while ignoring the quiet, constant and potentially massive impact of fees on our wealth. The good news is that by understanding the arithmetic of active management and paying attention to the fees we are paying, we can make better-informed decisions about our wealth.




1 “The Arithmetic of Investment Expenses,” William F. Sharpe, Financial Analysts Journal, Volume 69, Number 2.
2 Expense ratio of Vanguard Total Stock Market Index Admiral fund as of June 11, 2014.
3 “Luck vs. Skill in The Cross Section of Mutual Fund Performance,” Eugene Fama and Kenneth French, Journal of Finance, October 2010.
4 “The Arithmetic of Investment Expenses,” William F. Sharpe, Financial Analysts Journal, Volume 69, Number 2.
5 “What Kills You and Your Investments,” Barry Ritholtz, Bloomberg View, May 21, 2014.