A seismic shift is upending the trillion-dollar business of managing money for both institutional and individual investors. From the accelerating movement of cash into passive index funds to the recent drop in fees in actively traded funds, there is mounting pressure on asset managers in all corners of Wall Street.
Yet the rebellion against high fees is nothing new. Almost from the time they set up shop a century ago, fund managers have been criticized for charging too much for a service that offered little or no advantage to individual investors. So why has the practice survived?
In the early 20th century, investment managers didn’t really exist. Brokers did, of course, and they charged commissions for buying and selling stocks and bonds on behalf of their clients. The system was rife with conflicts of interest, and eventually someone came up with the idea of charging a regular, predictable fee for managing investor assets.
The concept was championed by Arthur A. Clifford of Pasadena, Calif. Clifford styled himself an independent investment adviser, arguably the first of his kind. He offered something altogether novel: investment advice for a fixed fee to clients who could act on his recommendations. Significantly, the size of the fee had no relation to the amount of money the client wished to invest.
The Boston investment banker Theodore Scudder, who founded the firm known as Scudder, Stevens & Clark in 1921, also offered investment advice. But in a harbinger of things to come, he and his partners also managed those investments. In the process, the business of giving investment advice and managing assets became inextricably intertwined.
Equally significant was the fact that Mr. Scudder devised a fee structure that soon became the industry norm. He did not charge commissions; instead, he charged a fixed fee relative to the total assets under active management: the bigger the holdings, the larger the fee. By the end of the 1920s, at least 70 such firms managed the assets for wealthy Americans.
The first modern mutual funds, which enabled people of more modest means to put their savings in the hands of asset managers, also arose in that period. None other than Scudder, Stevens, and Clark founded the first no-load mutual fund in 1928. By the end of the decade, investors had a choice of more than 700 funds, the vast majority so-called “closed-end funds.” Almost all of them assessed fees using the same method that Mr. Scudder pioneered, typically some fraction of one per cent.
While the Great Depression of the 1930s destroyed many of these funds, they came back in vogue the following decade. And the fees they charged investors started going up, prompting calls for government intervention. In May 1958, the Securities and Exchange Commission asked the Wharton School at the University of Pennsylvania to undertake a study of the mutual fund business.
The study, published four years later, presented a scathing indictment of the industry, in particular for its many conflicts of interest. But the most noteworthy finding may have been that half of all actively managed funds performed no better than comparable “unmanaged portfolios.” In fact, as Irwin Friend, the lead author of the study, noted, there was “no relationship was found between performance and the amount of the management fee or the amount of the sales charge. It follows, on the basis of this evidence, that investors cannot assume that the existence of a higher management fee or a higher sales charge implies superior performance by the fund.”
The Wharton report found that, on average, the average mutual fund investor paid fees of approximately 50 basis points. This held steady, regardless of the size of the fund, even though the per-dollar operating costs were in fact lower in the bigger funds. In other words, investors didn’t reap any benefits from economies of scale. The study likewise found that retail investors paid more than institutional investors, even though “the expenses involved in advising mutual funds were less than those incurred in advising other clients.”
Market forces, which would normally put pressure on excessive or needless fees, had done little to solve the problem. As the New York Times summarized the report after its release, “one of the hallmarks of a market society is that the successful are rewarded and the unsuccessful penalized. But this rule does not seem to apply to mutual fund investment advisers, because there is no relationship between performance and fees.” Mutual funds simply stuck with investment advisers, whether they delivered good returns or not.
As a consequence, when the SEC commissioned its own study in 1966, it echoed the Wharton report, arguing that competitive forces had failed to place pressure on fees, despite the fact that the mutual-fund industry had grown swiftly in the intervening years. For that reason, the SEC recommended that Congress enact legislation punishing so-called “excessive” fees. But this went nowhere, and fees continued to creep upward.
The same happened to institutional investors such as pension funds. These pools of investor dollars originated during World War II, when the government imposed price and wage controls. Corporations padded employee paycheques by expanding retirement benefits. Banks offered to invest these accounts, but treated them as a “loss leader”: they charged little in the way of management fees because they could make money from the funds in other ways: brokerage commissions and interest on the money when they lent out the funds.
But then, in the late 1960s, Morgan Bank imposed a 25 basis-point fee on institutional investors. Conventional wisdom held that Morgan’s pension clients would go elsewhere. But they didn’t. In fact, they continued to stick to Morgan and the other banks hired to handle their assets even as rates continued to head ever higher, hitting 50 basis points by the following decade.
Mutual funds fared even worse. Their expense ratios (which reflect all costs associated with fund management, including investment advisers) kept climbing through the 1970s and beyond. Among equity funds, the average asset-weighted expense ratio, which stood at 0.54 per cent in 1960, hit 0.58 per cent in 1970, and then went even higher: to 0.64 per cent in 1980 and 0.89 in 1990. Yet in the same period, the amount of money in mutual funds increased 24-fold. So much for economies of scale.
Some individual investors rebelled against rising fees, moving into the first passive index funds, introduced in the 1970s. But most investors stayed put, even as fees went higher. In recent years, some economists studying the mutual fund industry have argued that fees levelled off and even began to decline by the 1980s or 1990s. But some scholars of finance have cast doubt on that claim, arguing that modest declines in expense ratios reflect a decline in transaction costs, not investment fees.
Regardless of the timing, though, one thing seems clear: asset management is a market to which change has come very, very slowly. Despite the long-standing, overwhelming evidence that the fees that come with actively-managed funds doom these investment vehicles to mediocrity over the long run, neither individual nor institutional investors have acted on their discontent in droves.
Until now. A steady drip of defections from actively-managed funds to passive funds -- and more generally, from high-fee funds to low-fee funds -- has turned into a torrent. It’s about time.
Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to the Bloomberg View.Report Typo/Error