Imagine you wrote an annual letter that was read by investors worldwide looking to you for guidance. What would you write about fund manager fees? When addressing the collective, there really is only one answer: the lower the fees the better.

Warren Buffett continually finds himself in such a position. His annual letter to shareholders of Berkshire Hathaway is surely one of the most widely-read investor letters published each year. And Buffett has addressed the issue of fund manager fees on numerous occasions.  Perhaps the most memorable was Buffett’s 2013 instruction to his wife on how to invest the cash that he plans to leave her in his will.

“My advice to the trustee could not be more simple: Put 10 per cent of the cash in short-term government bonds and 90 per cent in a very low-cost S&P 500 index fund.”

And this was not just a message to his wife, it was a message to the world. And when the world is your audience this can be the only message with regard to fund manager fees. Why? Because the net equity returns achieved by all investors in the world is simply the gross average market return, less the average fee paid by all investors. So the one and only way to systematically increase the average net return for all equity investors is to reduce the average fee. It’s that simple.

So should all investors promptly switch their holdings to low-cost index funds? Enter the Fallacy of Division which occurs when one reasons logically that something that is true for the collective must also be true for its constituents. Aristotle cautioned against making this mistake more than 2,000 years ago.

You see, while the global collective of all investors cannot outperform the market (indeed, they are the market), any individual investor absolutely can beat the market. So from an individual’s perspective, it is perfectly logical to pay higher fees to an active fund manager in whom they believe – in anticipation of higher net returns (despite the higher fees paid).

What is less logical, however, is the individual who owns a very large number of active fund managers. Diversification, while typically understood to be a necessary and important part of investing, makes far less sense in the context of active fund manager selection. If an individual holds a large portfolio of active managers, they will receive a highly diversified gross-return which will typically approximate the equity market index. The net return received will, therefore, be roughly equal to the market index return less the average fee of the selected active fund managers. This is the worst of both worlds: little chance of outperformance combined with substantial management fees. The moment one gives up the chance to meaningfully outperform the equity market, they should demand very low management fees. And low-cost index funds are great vehicles to deliver zero outperformance at a very low cost.

To outperform the equity market, one needs to invest – in a fairly concentrated way – with a small number of talented and disciplined active fund managers that follow a process which is logical and clearly understood by the investor. This style of investing can generate superior returns for the few that follow it. But this strategy will not work for the collective. This is an example of the Fallacy of Composition.

Outperformance is a zero-sum game: one can only outperform if others underperform. The concept works well, but only from the perspective of a subset of the collective. From the perspective of the collective, there can never be any outperformance. From the perspective of the collective, reducing management fees is the only game in town.


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