The investment industry can be a very backwards place in many respects. For instance, seeing the price of a product go on sale generally makes people happy and induces them to buy more of it. In the markets, when things go on sale from a market crash that’s when investors are the most scared and have the hardest time forcing themselves to make a purchase.
Also, with many goods and services it can make sense to pay up for quality. This theory that you-get-what-you-pay-for is something many in the professional money management business believe in as well, but it’s rarely the case in the fund management space.
A new study on pension funds sheds some light on this issue (courtesy of Chief Investment Officer):
According to a new study by conservative Maryland Public Policy Institute (MPPI), state pension funds that paid the highest in fees recorded inferior average returns than those with the lowest fees over five years ending June 30, 2014—a period that encompasses one of the strongest bull markets in history.
Specifically, the 10 states writing the biggest checks to Wall Street managers earned annualized five-year returns of 12.44% over this timeframe, the report said. This falls behind the 12.77% net-of-fees returns at the 10 funds paying lower fees.
So the funds paying the lowest fees have actually outperformed the funds paying the highest fees. Now, there is a caveat here in that many active funds typically underperform in a strong bull market. But the authors of this study found similar results when they ran the numbers in 2012.
It wasn’t just the low fee outperformance that caught my eye in this report. Just look at how close the returns are between these different funds, regardless of cost. The annual difference was just over 30 basis points. That doesn’t seem like much in a bull market that’s been producing double digit gains year after year, but it can make a huge difference in a low return environment.
Investors have been preparing for a lower returning markets for a numbers of years now. Eventually it will happen. The thing that surprises me is how many investors assume that increasing the fees they pay to managers or increasing the activity within their funds will help boost performance in this scenario. The evidence doesn’t support this view.
Here’s more from CIO on why it is that these institutional pools of capital pay up for performance:
The data firm found investors are willing to pay more—but only for peer-topping past performance. Products with top-decile returns over a three-year period were 42% more likely to win mandates than their bottom-decile counterparts.
Furthermore, more than half (57%) of assets won in 2014 charged fees in the top 50%, the report said.
Not only do professional investors chase performance, but they’re also willing to be more for it. In my book I tell the story of a large group of institutional investors at an industry conference who were unhappy with the suggestion by one of the speakers that you could achieve above average results at a lower cost:
You get what you pay for is an expensive theory, but one that all too many still believe in. It’s more or less a sales tactic, but one with a narrative that’s difficult to shake for many both inside and outside the industry.
It was far too counterintuitive for these investors to accept the fact that they could earn above average returns at a lower cost while giving up the opportunity for extraordinary performance at a much higher cost. The extraordinary performance was much harder to get and there was no way that all of them were going to be able to succeed in finding it, but how could they admit this fact and not even try? These are very competitive people. They all went to top colleges and universities. Most attended the top business schools, obtained the prestigious CFA designation, or both. Everyone in the room was intelligent and extremely qualified. Investing can be a cutthroat business. Everyone wants to be the best investor by making the most money possible in the shortest amount of time. Unfortunately, it’s just not possible for every single professional investor to be in the top echelon of the performance rankings. This can be a difficult realization to come to.
This isn’t an index fund vs. active fund debate either. It’s a high fee vs. low fee issue. It’s determining how much you can reasonably pay for certain exposures within your portfolio without creating an unbeatable hurdle rate in an ultra-competitive marketplace. The assumption that paying higher fees for access to top fund managers will somehow protect your portfolio is misguided. Plus, the fees are guaranteed. The performance is not.
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My new book, A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan, is out now.