The Cost of Doing Business for Active Mutual Funds

I received a great deal of feedback on my post from a few weeks ago about passive inflows and where I think active managers have a place in the fund world of the future (see Putting Passive Inflows Into Perspective).

It’s easy to demonize the active fund management industry what with their high fees and underperformance issues, but it’s not always so black and white. There are firms that charge higher fees simply because they can, but not everyone is out to screw over the little guy. An old friend who works for an active mutual fund company emailed me with the other side of the story. Here are some of his points that I found interesting:

There is a huge bottleneck for fund companies to charge lower fees to their shareholders, and it isn’t greed. It’s a combination of platform fees and stupid regulations. The cost of us for “helpers” is pretty massive, but none larger than this one: regardless of what platform (Schwab, Fidelity, Ameritrade, etc.) the cost to fund companies to have their funds trade on them is 40 bps. The platforms have held almost completely fast on this — it would be a fascinating study in market collusion since there is almost no price variance and very few companies can negotiate. Vanguard is big enough to provide on its own platform. Fairholme is one which has enough name recognition to negotiate. Everyone else has to pay at what is a fairly high rate. How the brokers have held the line here is a mystery to me, but the knock on effects are obvious since it is much, much more painful for fund companies to lower fees since their biggest cost center (the platforms) do not negotiate.

James Altucher interviewed the president of Yuengling (one of my favorite beers) this week on his podcast and the topic of distributors came up. Yuengling made it sound like the distributors are the gate-keepers of the adult beverage industry — good luck getting shelf space without them on your side.

According to this fund manager, this is basically how the mutual fund industry works as well. The cost of doing business is very high because of the regulations involved and the way the platforms are set up to sell the funds. Unless the fund shop has the scale of a Vanguard or Charles Schwab the costs are very cumbersome. The solution, according to this friend, is to sell the funds directly, but that’s not very easy to do in an entrenched industry.

This person doesn’t consider passive investments a threat to their fund platform because they are highly differentiated with large tracking error, but wanted to set the record straight on the fee issue. Most upstart firms would welcome the chance to lower their fees, but it’s very difficult with the way that the mutual fund industry is set up. I’m sure the regulations were set up with good intentions, but there are always unintended consequences.

I’m always willing to look at both sides of every argument. I didn’t realize the extent of the costs involved for active funds that don’t have the scale to negotiate. This doesn’t change anything about the fact that lower fees are better for the investment consumer than higher fees, but it does help put active management fees into perspective.

Further Reading:
Not All Active Funds Consistently Underperform

And listen to the Altucher podcast if you’re interested in a case study on how to run a business the right way (Stansberry Radio)

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