Do Active Funds Need a New Fee Model?

The long-term struggles of active funds versus index funds is primarily a problem of fees. There are other factors that influence the success rate of active strategies – most notably, in equities, the performance of small and medium sized companies relative to their larger counterparts – but it is the compound impact of highs costs over the long-term that causes most of the damage. Attempts to create charging structures that diverge from the simple % of assets under management model are typically focused on the use of performance-based fees, but in the vast majority of cases these (somewhat counter-intuitively) increase the negative asymmetry experienced by investors. Too often we pay lavish short-term rewards for underwhelming long-term results. To improve the odds of active fund success, the fee model needs a rethink.

One of the most egregious problems faced by fund investors is the problem of scale. As the size of a fund grows its profitability for an asset manager increases materially. Not just in terms of the revenues generated, but the profit margins. High operating leverage means that the marginal cost of an additional $100m invested into a $10bn fund is low. It is in the interests of asset managers to keep growing their largest funds.

There are two major difficulties that this model causes investors. First, is that the benefits of scale rarely have a material impact on the costs that they incur. As fund size grows and costs are spread across a greater revenue base this results in an improved margin for the asset manager but rarely a meaningful fee saving for the investor. Second, above a minimum threshold the growth in assets of a fund reduces the potential for future excess returns. Rising fund size means that the opportunity set is reduced, flexibility is compromised, and liquidity deteriorates.  

We are left with a situation where the investor faces a lower probability of outperformance whilst the profitability of a fund for an asset manager increases.

This is a major incentive problem for asset managers and creates a jarring misalignment with the objectives of their investors. Undoubtedly it is one of the primary reasons that funds are so rarely closed due to capacity constraints.

Is there a way of mitigating this problem and improving the situation for fund investors?

One option is to apply a $ revenue cap. How would this work?

A fund would launch with a standard fee level, let’s say 0.5%; but there would be a provision stating that all revenue earned over a certain amount ($Xm) would be reinvested into the fund. This would mean that above a given threshold of assets under management the benefits of scale would accrue to the underlying investors and provide compensation for the cost of asset growth in terms of declining performance potential. It would also greatly reduce the incentives of asset managers to ride roughshod over capacity concerns.

The advantages of such an approach are clear, but what are the potential drawbacks:

– Asset managers might increase fee levels to compensate for the cap. This is certainly possible but would only serve to further inhibit future performance.

Asset managers may launch more products to mitigate the impact of capped costs, in particular launching similar / mirror versions of the constrained strategy. The last thing anybody needs is more funds.

It might subdue innovation and development as large, ultra-profitable funds are no longer able to subsidise fledgling ventures or research. I am not sure I believe this is a genuine problem even as I write it.

There may be technical difficulties (documentation etc…) if the size of a fund declines and investor fees increase. This doesn’t seem to be an insurmountable hurdle, but fee variability is not ideal.

A $ revenue fee cap is clearly going to be unattractive to the largest and most profitable asset managers, and this is not the only way that the current fee model can be improved. It is, however, an area that is ripe for disruption and where there is significant potential to improve both investor alignment and outcomes.



My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here.


12 thoughts on “Do Active Funds Need a New Fee Model?

  1. Pingback: Bacaan akhir pekan: Kembalinya Vanguard yang telah lama ditunggu-tunggu ini mengingatkan kita bahwa hari paling gelap sebelum matahari terbit – IDN Rujukan News

  2. Pingback: Weekend Reading: These Vanguard Expected Returns Remind Us It's Darkest Before The Dawn - Monevator - Daily News Era

  3. Pingback: Weekend reading: these Vanguard expected returns remind us it’s darkest before the dawn - Laolita Group

  4. Pingback: Weekend reading: these Vanguard expected returns remind us it’s darkest before the dawn - Comas Family

  5. Pingback: Bacaan akhir pekan: Kembalinya Vanguard yang telah lama ditunggu-tunggu ini mengingatkan kita bahwa hari paling gelap sebelum matahari terbit – Idn Erudisi

  6. Pingback: Weekend Reading: These Long-awaited Vanguard Returns Remind Us It’s Darkest Before Dawn – Monevator -TheFM - TheFM

  7. Pingback: Weekend reading: these Vanguard expected returns remind us it’s darkest before the dawn - Belman Partners

  8. Pingback: Weekend reading: these Vanguard expected returns remind us it’s darkest before the dawn – Tower Group Investments

  9. Pingback: Weekend studying: these Vanguard anticipated returns remind us it is darkest earlier than the daybreak - Invesaid

  10. Pingback: Weekend Reading: These Expected Vanguard Returns Remind Us It’s Darkest Before Dawn – Marketpips

  11. Pingback: Weekend studying: these Vanguard anticipated returns remind us it is darkest earlier than the daybreak - Luxalent

  12. Pingback: Weekend reading: these Vanguard expected returns remind us it's darkest before the dawn - Feed Dollar

Comments are closed.