Say goodbye to 2-20 and help to zero management fees

In February, passive investing powerhouse Vanguard cut the expense ratios on 68 mutual fund and exchange-traded fund shares across its platform for the third time in three months. According to Barron’s, the total estimates savings from these cost cutting actions was $143 million across 124 fund shares over three months.

It didn’t take long for competitors to follow suit. Last month Fidelity decided it was going to try and match Vanguard by cutting the management fees on some on 14 of its 20 passive products taking the average management fee across its fund range from  9.9 basis points instead of 11 basis points, a price it claims is cheaper than that of Vanguard.

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If these efforts by passive managers to out-do each other continue, it won't take long for this race to the bottom to hit, well, the bottom. zero management fees

This is not a new development. Interestingly, zero management fees have been a staple in the active management industry for some time, and today they remain an attractive structure for investors.

Zero management fees dominate 

According to a recent note from Mark Chapman, an analyst at Aquamarine Capital, the investment manager started by Guy Spier, there are three investment advisers registered with the SEC with Assets Under Management of over $100,000,000 who only charge a performance fee and no management fee. For state-registered investment advisers with AUM under $100,000,000, there are only eleven advisers that manage active private hedge funds and who only charge a performance fee. However, according to Chapman, this number might be higher because of the way managers report to the SEC as it's not possible to separate individual accounts. Still, it appears that's there's only a small number of investors that do not charge a management fee and instead only have a performance-based compensation plan.

Of these managers, many appear to believe that they should be well rewarded for beating the market with an average performance fee of 25%. Costs reportedly vary considerably with some charging up to 30% and others up to 8%.

The most interesting takeaway from Chapman's commentary is the revelation that today most new managers, if given a choice, were more likely to "pick a zero management fee class rather than a Two and Twenty class, signifying a general investor recognition than managers should be compensated for performance." However, existing investors in funds offering both options in different categories, were "often loathe to shift to the zero management fee class as they would likely crystallise a taxable gain on the change in class."

This data is revealing because it shows a new respect for investors. Starting off without a management fee is tough because there's nothing to cover initial expenses with, and there's no protection against a down market in the first few years.

Chapman speculates that it's the drive by passive funds to lower costs that are inspiring managers to slash fees. Investors today realise, more so than ever before, that most active managers struggle to outperform, and therefore they are not worth their fees. As a result, in an environment where only the strongest survive, by beating the market and earning performance fees, only those managers who are confident of outperforming will be looking to raise capital. In other words, there's now no room for bad active managers in the market.