One of the biggest arguments against active management is the fee structure of actively managed funds. With an annual charge of 100 basis points or more levied on investors in active funds, even if these funds track the market, they will underperform. In order for an investor to beat the market by owning an active fund, the fund would have to outperform the market by at least 100 basis point every year to justify its fee, which is almost impossible.
The classic 2/20 hedge fund model presents an even larger hurdle. A firm with this fee structure in place would have to beat the market by at least 200 basis points every year excluding pass-through fees just to justify its experience – that’s without taking the profit share.
Investors and pension trustees are really starting to wake up to the detrimental effects such fees are having their wealth. The latest study on the topic comes from the American Federation of Teachers, which places the total cost of fund fees for the 12 largest retirement funds in the US ($787 billion in assets under management) over the past five years at $19 billion.
Fee structure – Pension Funds Pay $30bn extra
The Big Squeeze: How Money Managers’ Fees Crush State Budgets and Workers’ Retirement Hopes documents the harm to pension funds and state budgets caused by the standard fund manager fee structure, where managers are paid up to 2 percent of assets under management, plus a “performance fee” (also known as carried interest) of up to 20 percent of annual profits.
To reflect the actual state of the industry rather than using a blanket 2/20 fee model, the study uses a “1.8 and 18 model to account for the fact that some pension funds have already begun negotiating a lower rate than 2 and 20.” After calculating a base financial burden based on 1.8 and 18, the authors of the study then consider a hypothetical fee model of 0.9% and 9% and assume a sustainable rate of return of 7% to estimating total savings for pension funds sampled.
Based on this model that each of the 12 pension funds considered would have been able to save $1.8 billion over five years by adjusting to the lower 0.9 and 9 rate for “hedge fund, private equity and co-mingled real assets.” In total, the funds in the study would have saved $3.8 billion per year in alternative fees for a total saving of $19 billion over five years. The average fund would save $317 million per year by cutting alternative fees in half.
As pension management is a long term business, it is important to consider the impact of these fees will have over what many consider to be the ultra long term, not just the next one or five years. According to the Big Squeeze Report, by adopting the lower 0.9 and 9 model, the 12 funds considered will save $30 billion over three decades. Considering the total deficit of all US pension funds is around $1 trillion, this potential saving is extremely significant.
Full study can be found here