What is the true cost of professional management if the fees run somewhere between 50 and 100 basis points? To figure this out let’s use 90 basis points (0.9%) charged by one well-known financial advisor as it is about average for the industry. We need to make a few more assumptions and one is the average return of the U.S. stock market. We will use 8.7% or a value not far off the annual historical average for the past 100 years. Readers can insert their own numbers based on this example.
1. If you are fully invested in the market assume your average annual return is 8.7% or 870 basis points.
2. If the management fee is 90 basis points, then the manager needs to return 870 + 90 or 960 basis points just to keep up with the market. Remember, the return to the investor is market return minus fees.
We will forget about the managers who are unable to beat the market, although they should not be quickly dismissed as the majority fall into this bucket every year. Instead, take the optimistic view that you were successful in locating a sharp money manager who is able to outperform the market every year by 50 basis points or 0.5% every year. While this is good news, it is not great as the holder of the portfolio is still losing out to the market by 40 basis points per year. Market return of 870 basis points plus 50 basis points in alpha equal 920 points of return. Subtract 90 basis points for fees and the investor ends up with 920 – 90 = 830 basis points of return or 40 basis points behind the market.
And now the critical question arises. How much are you paying for that 50 basis points of alpha that is generated by the wisdom of the professional manager? If management fees exceed the alpha (Alpha = 50 basis points in this example) added by the manager, you are paying more than 100% to add any alpha to the portfolio, and this is what is happening to the vast number of investors who pay for professional money managers. If you pay 90 basis points in management fees to a manager to add 50 basis points of alpha, you are paying well in excess of 100% to beat the market. This is a high cost considering most manager do not beat the market year after year.
Instead of thinking about management fees, and stopping there, consider what fee you are paying to add alpha to the portfolio. Even if the manager produces 2% of alpha (exceeds the market by 2% or 200 basis points) and your fees are 1%, you are paying a very high percentage to capture that alpha.
As a private investor, if you spend a little time thinking about market return, fees, and the uncertainty surrounding the possibility of a manager adding alpha to the portfolio, you will begin to understand why I think individuals should manage their own money. Most investors would be better off buying only VTI or VT and doing nothing else vs. paying for management fees.