Fees Eat Diversification’s Lunch by SSRN

William W. Jennings

U.S. Air Force Academy – Department of Management

Brian C Payne

US Air Force Academy

December 26, 2014

Abstract:

Diversifying into more-exotic asset classes comes with different price tags. We consider investment management fees relative to various asset classes’ diversification benefit. We show that the fees on diversifying asset classes are astonishingly high relative to their diversification benefit. Diversification is often spoken of as the only free lunch in investing, yet we show that it is not free and is properly considered only in light of its costs. More-exotic asset classes typically come with higher investment management fees, which offset their diversification benefits. Because there is meaningful cross-sectional variation, fee levels need to be part of asset mix decisions and strategic asset allocation.

Fees Eat Diversification’s Lunch – Introduction

In a Perspectives editorial in this journal, Charles Ellis (2012) reframed traditional thinking about investment management fees, saying they should be measured, not as a percent of assets under management, but rather as a percent of active management alpha. Ellis contends that, properly measured, “fees for active management are astonishingly high”.

Earlier in this journal, Leibowitz and Bova (2005) show that exposure to the U.S. equity market is the dominant risk driver for most asset classes and most portfolios. Their “allocation betas” capture the bulk of the risk in diversified institutional portfolios. After accounting for their allocation beta, an “allocation alpha” remains. This allocation alpha reflects the true diversification benefit beyond that achievable by simply changing the portfolio beta with core assets.

Ellis focuses on fees relative to active management alpha. Instead, we consider fees relative to different asset classes’ diversification benefit, or allocation alpha. Coupling these findings from Ellis (2012) and Leibowitz and Bova (2005), we consider fees relative to diversification benefit. We contend that:

  • most diversifying asset classes have risks chiey characterized by their exposure to U.S. equity beta and relatively small truly-diversifying Leibowitz and Bova “allocation alphas,”
  • most diversifying asset classes have higher investment management expenses than core asset classes, and
  • these facts combine to dramatically reduce the true diversification benefits for many asset classes.

We merge the insights of Ellis (2012) and Leibowitz and Bova (2005) to show that the fees on diversifying asset classes are astonishingly high relative to their diversification benefit. Ellis asserts, “Investors should consider fees…as incremental fees versus risk-adjusted incremental returns above the market index” (p. 4). We contend the same for the fees associated with higher-cost diversifying asset classes|that is, investors should consider the cost of diversification against the true value-added from that diversification. We demonstrate the fee impact by focusing on fees relative to allocation alpha.

Figure 1 contrasts three perspectives on fees, using institutional-sized investments in high yield bonds as an example. Panel (a) is the traditional view, where investment management fees are considered relative to assets under management (AUM). They are clearly small. Panel (b) highlights that fees are larger as a proportion of the expected return. Panel (c) shows our point of view|that fees are “astonishingly” high relative to their diversification benefit, or allocation alpha.

Diversification

Diversification is often spoken of as the only free lunch in investing. We show that it is not free. We begin by reviewing the Leibowitz and Bova (2005) model. We then apply this model to a third-party set of capital market assumptions and high-quality investment fee data. We demonstrate that fees re-order the relative benefits of different diversifying asset classes. We conclude by discussing the investment implications of our research.

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