Updated January 2021
ADVISORY FEES AND THEIR EFFECT ON PORTFOLIO PERFORMANCE
Abstract: Investors often find management fees hard to determine since they are typically swept from the client's money market account into the advisor's account or taken out of fund expenses or reported in an opaque manner. Management fees from major brokerage firms are often as high as 2% and hedge funds usually charge 2% plus 20% of the profits. Academics have studied the effect of management fees on returns. In a 60% equity and 40% fixed income portfolio a 1% fee takes 27.7% of the inflation adjusted expected return annually before taxes. This drag on returns compounds over time. The client's money, however, bears the risk over time, not the advisor's.
INTRODUCTION: Several articles on our website review research making it clear that an investor's chances of doing well in the investment markets is very significantly improved if they avoid active management and pursue a globally allocated multi-asset class passive and index investment strategy. This article examines an additional problem with active management, high fees that reduce portfolio growth during the accumulation phase in working years and distribution phase during retirement. High fees can be charged if investors can be convinced that active managers have special talents and can outperform passive and index portfolios.
On May 28, 2011 the Wall Street Journal published an article noting that for the first time the SEC is requiring investment firms it regulates to publish plain-English descriptions of their investment strategies on their websites. Advisors are still not required to post fees on their websites or in marketing material and few do. The SEC's goal is to help investors "better evaluate their current advisors or comparison-shop for a new advisor." Firms that charge clients commissions rather than annual fees aren't covered by the new rules and most firms do not make it easy to determine advisory fees.
An article in the Financial Times (6-6-11) reports research done by Swiss-based "My Private Banking" on the websites of the world's 40 largest wealth managers. The conclude, "The US fared the worst, with not even one large wealth management player scoring a single point on the consultant's seven-point scale for disclosing performance data, and only one, Deutsche Bank, scoring points for 'precise' fee disclosure." A casual perusal of several US advisory firm websites in 2016 reveals that only a few post fees and most are vague about their investment strategies and performance. The Wall Street Journal article referenced above cites one recent study showing that the top quartile of advisory fees averaged 2.08% with the bottom quartile averaging 0.81%. We have spoken with several investors using major brokerages and "wrap" fee accounts who were paying as much as 2.5% yet had no clear idea of what they were being charged. Know how much you pay for investment advice. A typical fee based investment advisor who selects mutual funds, bond managers, hedge funds of funds, and other investment vehicles will charge 1.0% with their downline fund managers taking another 1%. Not surprisingly, the advisory firms' quarterly fee sweeps from client accounts are typically noted inconspicuously within the cash accounting entries on their broker/custodian statements. Investors in hedge funds, private equity, and venture capital usually pay a 2% fee plus 20% of the profits and what their money is invested in is often hard to determine.
Paul Farrell on Marketwatch (4-10-12) mentions a study prepared for mutual fund industry insiders by the Fund Research Corp., FRC, "Predicting Mutual Fund Performance II". FRC studied funds in five asset classes; US equities, international/global equities, corporate bonds, government bonds, and municipal bonds. They tested ten variables often used to predict mutual fund performance and select mutual funds likely to outperform. These included past performance, Morningstar ratings, expense ratios, asset size, and four risk-volatility measures; alpha, beta, standard deviation and the Sharpe ratio. FRC concluded that only one of these variables predicted future mutual fund performance-the expense ratio. In other words, higher management costs predict and produce lower investor returns. What a surprise!
A later study by Morningstar's Kinnell (Tuchman, CBS Marketwatch, 6-5-14) found the same to be true in 2009 and 2010 as markets bottomed then soared higher. Fees strongly signaled performance outcomes. Tuchman concludes, "active management is less than useless". Though Morningstar's analyses were done on actively managed funds, there is little reason to expect the case would be different for fees charged by advisors specializing in the management of diversified passive and index portfolios. Many managers charge 0.5% or 1% or more for managing DFA equity asset class portfolios or passive and index portfolios. Our EAM clients receive full service in passive and index portfolios for under 0.1% annually and their management fee is fixed. We have very rarely changed a client's fee and only if the time involved in managing assets has increased significantly. Intelligently allocated passive and index portfolios will produce net returns for investors after management fees that will be higher when the advisory management fee is lower.
The effect of advisory fees on investor's post fee net investment returns is best illustrated through looking at probable long-term inflation adjusted returns in equities and fixed income. Academic analyses of long-term data going back to 1927 and in many cases the late 1800's indicates that a globally diversified equity portfolio is likely to return 5% with short and intermediate bonds returning 1.0% to 1.5% and cash and cash equivalents returning 0.5% (Dimson et. al "Triumph of the Optimists", DFA/Fama-French/Ibbotson data). These are inflation adjusted returns. They are not the juicer numbers investors are consistently regaled with from the investment community. The financial media and industry favors performance numbers not adjusted for inflation and carefully selected time frames in the past where returns have been the highest. Percentage based advisory fees are calculated on returns not adjusted for inflation so they also rise with inflation if the portfolio is rising in value due to inflation.
During the working stage of life when families are accumulating assets high fees reduce the growth of assets that will be available during the distribution stage in retirement. During the distrubition stage high fees reduce money available for living expenses. If we take a globally diversified 100% equity portfolio and assume it will yield an inflation adjusted return of 5% long term, a 1% fee skims off 20% of returns annually and that drag on portfolio returns compounds over time. A 2% total fee, not uncommon in the industry if a financial advisor charges a fee and picks active mutual funds or an investor is using a wrap fee with a major brokerage firm, takes a stunning 40% of the probable annual return. If we take a conventional pension plan with 60% equity and 40% fixed income we can reasonably expect an inflation adjusted return of 3.6% long term (.6x5% = 3% + .4x1.5% =. 6% or 3.6% for the total portfolio). An advisory fee of 1.0% takes 27.7% of the expected annual return and the handicap on returns created by the fee compounds over time. An article by Scott Burns in 2001 reported on a study done by the Employee Benefit Research Institute which found that a 2% advisory and management fee takes about 75% of the long term expected return in a 60% equity and 40% fixed portfolio over 30 years. On a typical portfolio allocated during retirement at 40% equity and 60% fixed income a 1% fee takes 34.5% of annual expected returns that could be spent during retirement. For most investors, fees this high will take a significant chunk out of their lifestyle during retirement. Of course, during accumulation and distribution it is the investor's money that is at risk, not the advisory firm's money.
As we note in articles elsewhere on this site we cannot be certain as to which asset classes will do best in the future for periods of 30 years or longer. When one begins investing or retires can make a big difference in the returns one receives over time yet future returns aren't all that predictable. If fees are high and returns are low for an extended period investors may receive and gain little or nothing or lose money. Another seldom mentioned risk investors take is that active managers occasionally make big mistakes and end up with numbers far below market averages. And, the return estimates presented here are based on linear calculations during accumulation and withdrawal stages. Real world returns are not at all linear in their compounding and volatility in returns almost always decreases long term total portfolio returns.
CONCLUSION: High advisory and management fees make a very significant difference in the rate investment assets grow over time and significantly reduce income generated during retirement when portfolio allocations tend to be more conservative and have lower expected returns.