Could lower fees ever be bad for investors?

A topic of considerable interest in investing circles today is the current boom in indexation and low-fee passive investing. It is certainly worth thinking about given the global exchange traded fund (ETF) space has grown to more than US$4 trillion, according to data provider ETFGI.

A lot of thought-provoking work on the space is currently being conducted by the likes of Steven Bregman and others. For value investors who believe that assets should only ever be acquired for less than they are worth, the primary flaw of indexation is that no concern for the price being paid for the underlying assets is given by the investor. Without any concern for the price being paid for an asset, the probability that one is consistently underpaying for assets must surely be close to zero.

Yet US$4 trillion has already accrued to this style of investing, so there must be some attractive features. And surely the most popular of these is the low management fee that is typically associated with index funds and other passive ETFs. All else being equal, lower fees are naturally a good thing for any investor. But all else is sometimes not equal. At least in the world of active investing, there is an interesting argument as to why low fees are potential sub-optimal for investors (believe it or not).

The one sentence summary of the argument goes like this: lower fees, means higher required funds under management, which means a smaller opportunity set and finally, a lower probability that outperformance will be generated for the end investor.

The link between fee, fund size and opportunity set is not entirely obvious but one well worth considering. Here is the rough maths behind it. Imagine an actively managed global equity fund that invested only in businesses with market capitalisations of at least $1 billion and daily liquidity of at least $5 million per day. These constraints result in around 5,000 businesses listed on the major global stock exchanges from which to choose. Such a strategy could be maintained all the way up to a fund size in the single-digit billion dollars.

Imagine, now, that particular fund manager were to pursue an alternative strategy under which he or she cut the management fee significantly (to compete with passive ETFs). Let’s say the fee was cut by a factor of 5 or 10. Then, naturally, it would take 5 to 10 times the assets to generate an equivalent amount of revenue for the manager. But here is the rub: the fund’s opportunity set would shrink materially.

For instance, if tomorrow the fund manager woke up to $50 billion of capital in the fund, the opportunity set would be down to around 300-400 global businesses. Add another $50 billion, and the manager would have only around 150 global businesses from which to choose. With significantly fewer businesses from which to choose, the probability that this fund manager can compound returns at rates as high as yesterday has surely diminished significantly.

Food for thought: very low fees means very large scale; and very large scale – at least in the world of active equity funds management – means a very small opportunity set. And a smaller opportunity set must lower the probability of very high compounded returns.

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