This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on Oct 5 - 11, 2015.

The Fund Industry: How Your Money is Managed is a detailed guide to the world of mutual funds and the investment management industry. In this excerpt, authors Robert Pozen and Theresa Hamacher discuss the management fee, which they say, is by far the largest component of a fund’s ongoing expenses. 

WHILE a management company may make a profit providing specific services to a fund, those profits are generally quite small relative to those from the management fee. Table 5.3 shows the annual expenses for the hypothetical Avon Hill Stock Fund, a US$6 billion actively managed stock fund distributed through the intermediary channel. (This table includes only those costs that are part of the expense ratio.)

As you can see, the management fee is by far the largest component of a fund’s ongoing expenses. It specifically pays for investment management services from portfolio managers who work for either the management company or an outside subadviser. And it more generally compensates the management company for the use of its brand name, for taking the risk of setting up the fund, and for organising its distribution. It is normally the main source of a mutual fund management company’s earnings.

Management fees are expressed in basis points, representing a percentage of a fund’s assets. The level of these fees varies by the type of assets the fund invests in. Because they are the most difficult to manage, stock funds have the highest management fees on average, while money market funds normally have the lowest.

For many funds, the basis point charge has breakpoints, dropping once assets reach a certain level. For example, an equity fund might have a management fee of 50 basis points for the first US$500 million of fund assets and 45 basis points for fund assets above that threshold. The breakpoint may be based on just that fund’s assets, on total assets in the entire fund complex, or on the assets of a subset of the funds within the family, such as all equity funds. Breakpoint pricing is extremely common.

The level of the management fee is the single biggest factor determining the fund’s expense ratio; as a result, total expenses also depend on the type of fund. (By contrast, other expenses tend to be fairly constant for all fund types.) Table 5.4 shows the range of expense ratios for the different categories of open-end funds, excluding the bottom 10% and the top 10%. It also shows the median fee.

As the largest component of fund expenses, it shouldn't be surprising that management fees have attracted considerable controversy. Adding fuel to the fire is the high levels of profitability of the fund management companies. Over the 10 years ended 2013, the larger publicly traded mutual fund sponsors reported returns on equity averaging 20% for the period, despite the disruption of the 2008 financial crisis.

So even though fund expenses have been declining, industry critics argue that they haven’t come down enough. We’ll take a closer look at the critics’ case.

The critics’ case

The critics make three principal arguments:

Negative 1: Insufficient benefit from economies of scale 
The critics believe that growth in industry assets alone should have led to even lower fees. They argue that the industry has enormous economies of scale, meaning that expenses rise a lot more slowly than revenues. “It doesn’t cost much more to manage a US$7 billion fund than it does to manage a US$1 billion fund,” they claim. “So why does the industry charge shareholders seven times as much to manage the larger fund?” (Remember that management fees are based on assets.)

Negative 2: Other investors pay less 
And, say the critics, “It’s not just that management companies haven’t passed on their savings to their mutual fund shareholders, they’re actually charging other clients significantly less.” (Fund managers often run accounts for other large institutions, such as government and corporate pension plans, as well as for mutual funds.)

One much-cited 2001 study found that, on average, management companies charged their public pension plans half as much as they charged mutual funds, expressed as a percentage of assets under management. 

Negative 3: Non-competitive market 
Underlying both of these complaints is a more basic concern — that the market for mutual funds is not competitive. Critics claim that investors are either unaware of the fees they’re paying or unable to switch to lower-cost funds because they’d incur capital gains taxes or back-end loads — and can present academic research to support this view.

At the same time the critics argue, the investors’ representatives, the members of the fund’s board of directors, are in the pocket of the management company and not diligent in driving down fees. They take a check-the-box approach to reviewing fees, without vigorously fighting for shareholder interests. For evidence, they point to the dearth of performance fee structures, as discussed in “Paying for performance”.

According to the critics, market power in the industry is highly concentrated. They note that at the end of 2013, the top 10 fund families managed over half of industry assets, and the top 25% managed almost three-quarters. And firms are consolidating at a rapid pace.

The rebuttal

The mutual fund industry’s defenders take issue with all of these points, contending that the industry is, in fact, extremely competitive. Their arguments include:

Positive 1: Fees decline with increasing assets 
First of all, they note, fees do decline as the level of assets increase. The prevalence of breakpoints in management fee contracts makes that a certainty. But the benefit to shareholders is not apparent when looking at an entire asset class because the mix of funds changes over time. For example, within the equity category, many of the new fund launches in recent years have been international stock funds, which are more costly to manage and usually have higher fees than US stock funds. So, for equity funds on average, a decline in fees on US stock funds will be offset by the increased representation of higher-fee international funds. Because of this changing mix, comparisons over time can be tricky.

Paying for performance

Another concern expressed about mutual fund fees — that they don’t align the interests of the investor and the management company. And it’s true that fund managers generally don’t get paid specifically for producing the thing that shareholders care about most — investment performance. In fact, while performance fees are growing in popularity, only 8% of funds charged one in July 2012.

Performance fees increase the management fee if fund performance exceeds that of a benchmark index or peer group, and they reduce the management fee if performance falls short. Note that the Securities and Exchange Commission requires that mutual fund performance fees have this symmetry, providing a reward for good performance with an identical penalty for poor performance. (Hedge funds have a very different performance fee structure. The hedge fund managers are usually paid a base fee plus 20% of the fund’s realised gains, but do not absorb 20% of the fund’s realised losses.)

If performance fees so perfectly align the interest of the fund’s manager and its shareholders, why are they so rarely used? It’s partly because fund managers don’t like the additional volatility in their revenues. They note that their income already depends on performance since a fund’s sales — and, therefore, the management fees based on the assets determined by the level of sales — are driven by recent results. On the other hand, their costs don’t vary much with performance.

At the same time, if the fee uses an index as a benchmark, it can be very difficult to actually earn positive performance fees, since fund performance — net of fees — is being compared to index performance before fees. Finally, if managers do well and earn a performance fee, they could, ironically, be penalised by cost-conscious investors for having a higher expense ratio, since performance fees must be included in the calculation.

One other drawback — performance fees can change portfolio manager behaviour. A fund manager who is already earning a high performance fee may invest conservatively to protect existing gains. On the other hand, a fund manager deep in negative territory has little to lose from taking a lot of risk.

Reproduced with the permission of John Wiley & Sons

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