Are you overpaying?

The headline, “Fund industry overpaid by $1,300 billion” caught my eye in the Financial Times on April 3^rd.  Hmmm, somebody finally put a number on it.  Here’s what FT reported based on a survey by the IBM Institute of Business Value regarding the fund management industry.

Value destruction in 3 easy pieces

The IBM survey of 2600 major users of fund managers, advisors and analysts concludes that the fund management industry is destroying $1,300 billion of value annually. More specifically:

• $300 billion in excess fees for funds that fail to beat their benchmarks

• $250 billion in fees for wealth management advisory services that fail to deliver promised above-benchmark returns

• $459 billion for inaccurate analysis by sell side research and trading, and credit rating agencies

Frankly, I am surprised that this article didn’t create more of a sensation when it was published.  Investment management is one industry where fees, and the value created (or destroyed) should be easily measured.  A $1 trillion+ overpayment certainly is an alarming kick in the head.

Unless we’ve been kicked there many times already.

Maybe the response to the article was limited because it is not really new news. For decades there have been allegations that the fund industry delivers far less value than it charges for, and consistently puts its own interests above those of investors. Have we grown so accustomed to the uninspired performance and service ethic of the fund industry that it doesn’t shock us anymore?

Who me?

One issue, of course, is the breadth of the allegation. When the failure to deliver value is pinned on the entire industry, it is easy to think (or hope) that one’s own fund providers, analysts and advisors are above the fray. Still, anyone who uses an investment manager and/or holds actively managed funds should be interested in this report and its implications.

Every investor should consider the unpleasant question: Am I being overcharged? And if so, what can I do about it?

If you consider the fundamental failures this report identifies – funds that don’t meet benchmarks, advice that doesn’t lead to above-benchmark returns, and research and ratings that fail to accurately predict winners – what you have, in essence, is an indictment of active management. The report supports what many academics have told us for a couple generations now – even a smart fund manager with limitless research and supersonic computing power has no real predictive advantage over a random and representative selection of securities within an asset class (which is typically what a benchmark is). Paying a fee to a manager to pick securities that fail to systematically beat a relevant benchmark over the long term is a waste of money.

You can greatly reduce the chance you are overpaying by simply ignoring the temptation to try to beat the market through active management. If you instead seek to match the performance of well-conceived benchmarks within each asset class through the use of indexes, and pay an advisor not for hot fund selection, but for valuable guidance in quantifying goals, asset allocation, and prudent management of expenses and taxes, the risk of overpayment is greatly reduced.

“Sunlight is the best disinfectant”

US Supreme Court Justice Louis Brandeis was right on with this quotation. There’s nothing wrong with paying fees for services if what is delivered matches the expectation of the paying party. I feel most investors ask too few questions of their service providers, and tend to rely on brand names rather than due diligence.

We are living in an information age where every actor in the financial industry should be able to quantify performance and value. In particular, the performance of funds versus relevant benchmarks should be readily available – not just for the last quarter, but over several years.

Let the sun shine in on your service providers and you are far more likely to receive value in excess of cost.