A few days ago I spoke to a finance professor at Columbia University here in New York City who has been doing a deep dive on the financial management industry.
His results were pretty concerning.
One of the things that he said was that fund management fees have been dramatically declining over the past few years.
At face value this sounds like a good thing.
All mutual funds and ETFs charge fees, usually a percentage of the assets that they’re managing.
For example, the Vanguard 500 Index Fund is a mutual fund that essentially owns all the companies in the S&P 500 index.
This fund is not “actively managed”, i.e. there are no stock-pickers deciding which companies to buy.
Instead, the fund managers simply acquire shares of the 500 largest companies in America, irrespective of those companies’ prices, valuations, or prospects.
This is known as passive (index) investing.
And for providing this service, Vanguard charges a fee– precisely 0.04% of the fund’s overall assets.
0.04% is pretty low.
Years (and decades) ago, passive fund managers were able to milk their investors, charging well in excess of 1%, despite doing very little.
But lately those fees have been coming down.
According to the professor’s research, the average fees for passive funds are converging to about 0.11%.
Again, if you’re an investor, you’re probably thinking, “That’s GREAT!”
But there’s a problem.
Every mutual funds and ETF is going to incur certain expenses in the course of conducting their business.
They have to have office space, investor relations staff, a Bloomberg terminal or two, consultants, legal advisors, etc.
And last time I checked, Wall Street was a pretty expensive place.
On top of that they all have to deal with tax filing fees, regulatory filing fees, audit fees, transfer agent fees, and more.
This stuff doesn’t come cheap.
In order to cover all of these expenses, fees, and salaries, a typical fund is going to need to generate over $5 million in revenue per year if they expect to make any profit in the endeavor.
This is where it gets interesting.
If a fund needs to generate $5 million per year, but the average fees are around 0.11%, this means that a fund won’t be viable unless it has over $5 billion in assets.
($5 billion x 0.11% is more or less $5 million, which is what they need to earn.)
But here’s the problem– a LOT of mutual funds and ETFs fall WAY short of the $5 billion mark.
In fact, according to data I pulled from ETF Database, only about 2% of ETFs have over $5 billion in assets.
This certainly raises an interesting question: if fees are dropping, how is it that smaller funds and ETFs are staying in business?
How are 98% of the other ETFs generating enough revenue to stay in business?
The answer came during a meeting last week with some investment bankers who were advising a colleague of mine that’s currently raising capital for a fund.
They told him that the best way for the fund to make money is to buy the assets at a lower price, then sell the assets to the fund at a higher price.
In other words, if the fund is supposed to own shares of small-cap stocks, then the managers make money buying the stocks at $1 and selling them to the fund for $1.05.
The end result is that investors end up paying a higher price for the assets they want to own, and this really eats in to the overall return.
My friend was dumbfounded. This is a total violation of a fund manager’s fiduciary obligation to his/her investors.
A fund manager’s primary job is to ALWAYS do what is in the investors’ interest.
Siphoning off extra cash by overcharging the fund for assets as a serious breach of ethics.
And yet it has become standard practice now on Wall Street.
Clearly there are exceptions; a firm like Vanguard is legendary for running cost efficient operations with tiny expense ratios.
But if you’re thinking about investing in a smaller fund or ETF, spend a little extra time doing some due diligence to make sure the numbers add up.
If an ETF has, say, $200 million in assets and an expense ratio of 0.25%, there’s something else going on.
Running a fund is expensive. And there’s no way they can cover their costs on $500,000 per year (0.25% x $200 million).
Which means they’re definitely milking you in some other way.