Taking a cut.

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Why Fund Managers Skim Your Savings

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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When I open an account at a bank, I get charged the same fee whether I put in $100 or $10,000. This makes sense, since it doesn’t really cost the bank much more to hold $100 for me than to hold $10,000. 

But if I invest $10 million in a mutual fund, I’m typically going to pay 10 times more than if I invest only $1 million. This is because the mutual fund charges a percentage fee. Part of that fee goes to pay for the fund’s administrative and marketing expenses. But part of it is simply called a management fee or an investment advisory fee. It is just a percentage cut that the fund takes out of my investment every year. Typically, this fee is about 0.5 percent to 1 percent. Financial advisers also typically charge a percentage fee based on the assets they oversee. 

When money managers charge percentage fees, it means that the price you pay for having your money managed goes up when you have more money to manage. Why does this happen? Does the cost of managing money really scale linearly with the amount of assets under management, so that it costs 10 times as much to manage $10 million as it does to manage $1 million? 

For hedge funds, highly active mutual funds, private equity and venture capital, this might actually be the case. Many hedge fund strategies show dramatic outperformance with small positions, but when the positions get large, transaction costs quickly overwhelm the “alpha” (market outperformance). Similarly, it may be difficult for private-equity and venture-capital firms to find more than a certain number of high quality deals. For managers like this, whose strategies don’t scale up, it might make a lot of sense to charge percentage fees. 

But most mutual funds, asset managers and financial advisers don't use these high-alpha strategies. Most are very diversified, and they invest your money in broad asset classes and in many different stocks or bonds. For these low-alpha money managers, whose main services are risk management, diversification and convenience instead of alpha, costs almost certainly don’t go up by a factor of 10 when the amount of assets under management gets 10 times bigger. (Although big clients do often get discounts, especially from financial advisers.) 

So why the percentage fee? I have a theory. I think it’s a form of price discrimination. 

Here’s the basic economics. Every customer has a maximum amount that she is willing to pay for some good or service. This is called her willingness to pay, or WTP. If the price of a washing machine is $500 and your WTP is $1,000, you got a great deal, while if your WTP is only $510, you didn’t get much of a break. 

Merchants and sellers would love to know everyone’s WTP. If they did, they could simply charge every customer the maximum she was willing to pay. In fact, some merchants, such as car salesmen and real estate agents, try to talk to customers to figure out how much they are willing to pay, so that they can charge higher prices to people who will pay them. E-commerce websites try to do this by looking at your electronic data. This is called first-degree price discrimination. 

For many merchants, this just isn’t feasible. An alternative way to do price discrimination is to charge different prices for different groups, based on how rich you think those groups are. This is why movie theaters have discounts for seniors and students, who tend to be poorer. This is called third-degree price discrimination.  

Money management is a very special business. An asset manager typically knows how wealthy his clients are, because, well, he’s managing their money. A financial adviser may be able to get a more perfect idea of a client’s net worth than a mutual fund, which only receives a part of the investor’s assets. But almost money managers can get a general idea. 

So for money managers, third-degree price discrimination is easy -- just charge a percentage fee. The people with more money automatically pay more! 

Of course, you would think that wealthier and larger investors would realize that this is happening, and demand that money managers charge them flat fees, or a combination of a flat fee and a lower percentage. Why hasn’t this happened? Perhaps it’s because the percentages involved are usually small numbers. This means they can easily fly under the radar, especially if the stock market is returning 8 or 10 percent a year, or if interest rates are 5 percent. 

But interest rates are near zero now, and seem likely to stay low for a while. That makes it a lot harder for even an inattentive investor to ignore a 1 percent fee. Already, investors are starting to demand lower percentage fees from their managers and advisers. If this process goes on long enough, people may start to wonder why they are paying a percentage in the first place, instead of a flat fee. That would probably be a good deal for many investors, especially big ones who would get much larger discounts. But it would definitely put the squeeze on much of the money-management industry.

  1. Second-degree price discrimination involves quantities, with prices falling as more of a good or service is bought or sold.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net