With equity markets likely headed into a period of lower returns, fees of all kinds are coming under increasing scrutiny. Active management is under this spotlight, too—but it also offers a potential solution.
It’s only natural that fees don’t stand out as much when equity markets are churning out big returns year after year. A beta wave featuring double-digit annual returns can keep the spotlight off advisory and active-management fees—even if active managers are underperforming.
But the story often changes when market returns come back down to Earth. Suppose equity returns are running at 5 percent to 6 percent per year; that means a classic 60/40 stock/bond portfolio might deliver something like 4 percent or 5 percent.
Warming Up The Hot Seat
In these environments, fees stand out a lot more—and the “fee” seat can get quite a bit hotter. A passive—or mostly passive—design can’t boost market returns, and in many cases locks in underperformance. Active management can help, but many advisors still wrestle with a big issue: fees. How can you be sure an active manager can deliver alpha that justifies what it is charging?
Essentially, fees are like the 80-basis-point gorilla of active management. That number roughly equals the average management fee across active equity funds over the past few years. If an active manager can’t beat the benchmark by at least that much, it doesn’t help anyone.
Change Is Under Way On The Fee Front
The explosive growth of passive investing and greater scrutiny have been making a dent in active fees, with more funds launching lower-fee share classes and strong market returns boosting fund assets. Today, the average active equity fund charges a management fee of 71 basis points (Equal-weighted management fee for primary share class of US-domiciled active equity funds with greater than $100 million in assets as of May 31, 2018). So, the gorilla has already lost some weight. And all things being equal, lower fees are better for investors.
Performance fees are increasingly entering the discussion, too, as investors and advisors look for more innovative and flexible structures in the fees they pay for active managers and alpha generation. There are different ways to design performance fees, but the underlying principle is the same: fees are scaled to the fund’s relative performance.
Performance-Fee Innovation Could Change The Game