Someone told me last week that Friday was National Doughnut Day in the US. I’ve heard not all doughnuts come with a hole. What this introduction has got to do with the subject of this post will become clearer later. Or perhaps not. I just like doughnuts.
Last week I also met with a mid-cap equity long-short manager for a review of his fund and investment process. The chap was quite passionate, convincingly committed to his job and responsibilities even though he was not particularly good at communicating simple concepts in a simple manner. Where he really stumbled, bordering incomprehensibility, was when I asked why he charges what he does [1.75% + 20% absolute performance fee]. It was as if I had insulted him and his ancestry; I even heard him murmur “because everyone else does.”
Broadly speaking, companies in any industry price their products at what they can get away with. In competitive industries the margin of freedom to charge at will gets withered away with time and prices will show declining trends, especially in real terms. In fields where barriers to entry are high producers will continue to enjoy pricing power. In either case prices are set with a “cost plus” approach, including some compensation for the capital employed.
The active investment management industry may be a case of “high barriers”: for years, while assets under management grew substantially, the number of asset managers grew even more but management commissions stayed about the same (in terms of percent of assets managed). Recently there has been some concern regarding the whole active sector with particular emphasis on hedge funds (about time people woke up), but clearly not enough as my recent meeting demonstrates. John Bogle, founder and retired CEO of Vanguard, once proposed a way to value the contribution of an active manager at 25%-33% of the income paid out by a portfolio. Another attempt I’m familiar with puts the figure at 1/3rd of the excess return (alpha) of a fund. Since costs are far below almost any figure, I’m not sure what either method is linked to. We’re stuck with widely accepted ranges without knowing why. Why a performance fee when the manager takes no risk? Why no symmetrical 20% performance fee refund if results are bad? Why 1.75% + 20% and not, like in any retail product, 1.7499% + 19.9999% or perhaps 1.3499% + 23.999%, or whatever? Why, above all, has nothing happened to prices when the results have been disappointing?
Investors have been paying more or less the same for years while on average failing repeatedly to meet their goals; they don’t bother to look under the bonnet (investment process) and go after strategies with the best shapes (performance record). They are happily living with a pricing structure that smacks of accidental price collusion.