Illuminating The Compensation Confusion
The investment community is a great mystery for most investors. Whether they admit it or not, these same investors trust financial institutions with their personal fortunes with no clue about how it is being spent or what they will receive (or lose) in return. They are willing to go along with the millions of other people who have done something similar and report great success. For most people, this is enough information.
Reports of hidden charges, excessive fees and immense profits have lead industry critics, zealous regulators and opportunistic politicians to raise alarms. Alarms come in the form of stories in the press, new regulatory disclosures and restrictions, and laws that are intended to curb excesses. These alarms are raised with no accountability and no measurable effect on the problems they seek to solve. They do however have unintended consequences, evident in the cost of growing mountains of regulatory disclosures that investors throw away – unread!
Why Pay More And Get Less?
In fact, many investors get a great bargain in which they earn trillions of dollars and pay only a small fraction of that in expenses. For example, over the last 10 years, US equity mutual fund investors earned $2.6 trillion1 at a cost of $484 billion. The gains are more than five times the expenses.
Even with such results, the primary complaint is that investors could have done better. And they could have if you assume that expenses can be reduced while everything else remains unchanged. Such a complaint may appear reasonable at first but with a little scrutiny, it really is irrational. Before accepting the idea that expenses can be reduced with no consequences, it is necessary to understand the uses to which these expenses are put and why they vary from one institution to the next.
Much of the expense of investing goes to compliance. Long before you turn over your personal fortune, financial institutions must take a number of extensive steps to make it legal to offer investments. Additionally, institutions must also continuously work to remain in compliance after receiving your money. The very high cost of complying with regulations is paid through the expenses charged to investors. Reducing these expenses increases the investors’ exposure to fraud and abuse as well as regulatory violations.
Expenses also go to paying advisors to introduce investment ideas to millions of people and institutions and then to help them make selections from among the thousands of choices available. For those who discount the value of the advisor, consider that over 90% of investors learned about investing directly or indirectly from advisors! Arguably, without advisors, the investment industry would be one-tenth the size and there would only be one-tenth the capital for economic growth. Reducing the expenses used to pay advisors could have a devastating effect on everyone’s long term wealth and the economy as a whole.
Expenses are also used to pay for the behind the scenes activities that are required for the day-to- day business that keep the investments operating. This includes opening accounts for new investors, making changes for existing investors, answering questions and concerns, preparing investor statements as well as the required computer systems and infrastructure. Cutting these expenses to any great degree could result in chaos.
A portion of expenses pays for investment management. The portion used for investment management depends a great deal on who is actually managing the investment. The portion is greater when professionals are used to deciding on which investments to buy, sell and hold and when to take these actions. Such an arrangement is considered “Active Management” and is considerably more costly than the alternative. The alternative is Passive Management, in which a third party indexer makes these decisions. Whether Active or Passive, investment management is essential.
It should be clear that simply reducing expenses will have consequences but even so, there are opportunities for reductions. Reductions can come from efficiencies such as increased automation, reduced service levels and elimination of waste. These will only yield modest savings.
The massive differences in investment expenses come primarily from differences in scale. Many of the costs described here are fixed and unaffected by the number of investors being served. An example of a fixed cost is a regulatory filing that is paid once, regardless of the size of the investment or the number of investors. In this case, the cost to each investor in a small fund is greater than the cost to an investor in a much larger fund. Large investments have greater purchasing power that translates to lower costs to investors. For example, a computer that costs $1,000 for a single order may cost only $250 when purchased in batches of 100.
This is not to say that investments should always go to the largest providers. On the contrary, the overwhelming message is that it is folly to select investments based on the expenses. It is far more important to select your investments based on the best alignment with your personal situation, goals and willingness to take risks.
Louis S. Harvey, President & CEO, Founder and leader of DALBAR.
Source: DALBAR Quantitative Analysis of Investor Behavior (QAIB.com)