As an equity PM I used to tell clients who asked why we didn’t turn over their portfolio more often, “the only certainty in this business is that higher costs will lower your returns.” Morningstar has since admitted as much by conceding that a mutual fund’s expense ratio is a better predictor of future performance than the Morningstar rating.
In October the Vanguard blog included an excellent post on this effect, Stopping the Silent Killer of Returns. The author, John Ameriks, did a stellar job of framing how to think about management fees as a cumulative product over the time horizon of the investment period. He points out that the impact of fees isn’t only on high positive returns – it’s on paltry and negative returns as well.
Similarities in the Managed Futures and Health Club Industries
As a member of an inexpensive health club, I’m its least desirable customer. I exercise religiously. The club would be better off by selling memberships to people who never showed up. Most of its customers are just like that, so the club remains in business by luring people to sign up and then never show up, so the club is never too crowded. These transient no-show customers in effect subsidize my membership, because without them my membership would cost me a lot more.
In the mid-1990s I spent a couple of years in the managed futures world, which was eye-opening in terms of learning about what people are willing to pay for and how manager futures funds got sold. I hope it’s changed, and I suspect in some pockets of the industry it has.
Back then you could be a commodity trading advisor (CTA) with two different clients with very different return experiences from your service. In one case you’re trading at institutional, rock bottom commissions, and ably filling the client’s role for you in his portfolio. In another case you’re trading within an allocation in a broker-affiliated fund of funds at commissions that are 2x, 3x, 4x, or a higher multiple, so your great monthly results get pruned and your mediocre results seem horrendous. The first client might be unconcerned with your performance while the second one is wondering why you’re in a drawdown longer than any you’ve experienced before.
You might wonder where those sky-high commissions went – of course they went to the brokerage firm, but the firm then had to pay its sales people who won the business in the first place. This is why part of the calculus of manager selection for a broker-affiliated fund of funds included the trading strategy turnover – if it were too low, it wasn’t economical for the FOF.
Regardless of who benefitted, the shame of this circumstance was just how much high brokerage fees could impair a CTA’s performance.
I recall examining a CTA’s performance in the midst of what seemed like a record-setting drawdown only to realize that the drawdown was in the eye of the beholder (mine). To another client with no brokerage affiliation, the CTA was probably not in much of a drawdown at all. This became apparent not with the published database returns but only when you examined the CTA’s 13-column performance report, which revealed just how much the CTA paid in brokerage fees. Plug in a lower commission, and everybody’s happy.
The ensuing dynamic is this: occasionally funds generate good returns, but often some or several CTAs are in drawdowns. The broker-affiliated FOF has to find new CTAs to signal to its clients that it’s doing its job. Eventually the clients redeem and the FOF has to sell to new clients. Like low-cost health clubs who rely on a revolving door of no-show customers, the FOF needs good sales people to continually attract new clients. In order to compensate these sales people the FOF-affiliated broker has to charge the CTAs high commissions. And so on.
In the consumer products world being the low-cost provider is widely regarded as a dead-end strategy. Eventually there will be only so far you can cut costs. But in the financial world, high fees eventually become unsustainable; innovators who are also low-cost providers eventually can win out. See Vanguard, Schwab, SPDRs etc.