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 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 to manage. Does the cost of managing money really scale linearly with the amount of assets under management?
For hedge funds, highly active mutual funds, private equity and venture capital, this might be the case. But most mutual funds, asset managers and financial advisers don’t use these market outperformance strategies. For these managers, costs don’t go up by a factor of 10 when the amount of assets under management gets 10 times bigger. So why the percentage fee? I think it’s a form of price discrimination.
Every customer has a maximum amount that she is willing to pay for some good or service, 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 a break.
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 most money managers can get a general idea.
So for money managers, third-degree price discrimination is easy — just charge a percentage fee.
You would think that wealthier and larger investors would 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.
Noah Smith is an assistant professor of finance at Stony Brook University and a freelance writer for finance and business publications.
