I have been in the financial services industry for a little over 40 years and, until recently, I never wondered about the rationale for the traditional percentage-of-assets-under-management fee schedule. The more I think about it, the less it makes sense to me.
My first glimpse at the world of financial services was back in 1975 when I served as an intern at the Securities and Exchange Commission while I attended law school. I was assigned to the Division of Investment Management, which regulates mutual funds and investment advisors. Every firm I came in contact with at the SEC charged fees based on a percentage of AUM.
When I started practicing law in Washington, D.C. and later when I moved into the asset management business, it was the same thing. Everywhere I looked, there was the percentage-of-AUM fee schedule, complete with basis points and break points. Looking back on it, that fee schedule was just like the suits I used to wear to work every day. It was part of doing business.
I never heard anyone question the AUM approach to billing. I think if I had, my colleagues would have looked at me quizzically, said nothing and gone back to doing whatever it was they were doing before I demonstrated my complete failure to grasp one of the fundamental laws of the universe. It would have been like questioning gravity.
More recently, some people have started to question gravity, or least our industry’s version of it. Most of this heretical thinking has taken place in the financial planning world, where flat fees, hourly fees and retainers have become, if not the norm, at least semi-mainstream.
Denizens of the asset management world have staunchly refused to engage in this brand of heresy. Their approach to it seems to be, “If we ignore it, perhaps it will go away.” This is the same approach my mother used to recommend in dealing with bullies and bumble bees.
My thoughts on the AUM fee schedule are born from my perspective as what is sometimes referred to these days as a “fund strategist” or “third-party money manager.” Since joining the asset management industry in the early 1990s, I have worked for firms that managed portfolios of mutual funds and/or ETFs for financial advisors and their clients on an outsourced basis.
A couple of years ago dark and traitorous thoughts began to bubble up in my mind about the AUM fee schedule. I tried to fight them, but to no avail. I began to see my old friend, the AUM fee schedule, as, well, indefensible.
As the technology supporting our business has changed, so has the underlying economics. Whatever may have been the case years ago, today it does not cost our firm any more to manage a $1 million account than it does a $100,000 account. So how can we justify charging our clients as though it does? Although this fact is masked somewhat by basis points and break points, the larger an account gets, the more it pays in dollar terms. Why?
The best I can come up with when I wrestle with this question is the following. If an asset management firm makes a mistake trading a large account, the potential liability is greater than if it makes a mistake trading a smaller account. Using this logic, I charge larger accounts more in order to insure against my own incompetence. Hmmm.