What Is a Management Fee?
A management fee is a charge levied by an investment manager for managing an investment fund. The management fee is intended to compensate the managers for their time and expertise for selecting stocks and managing the portfolio. It can also include other items such as investor relations (IR) expenses and the administration costs of the fund.
Management Fee Explained
The management fee is the cost of having your assets professionally managed. The fee compensates professional money managers to select securities for a fund’s portfolio and manage it based on the fund’s investment objective. Management fee structures vary from fund to fund, but they are typically based on a percentage of assets under management (AUM). For example, a mutual fund's management fee could be stated as 0.5% of assets under management.
Wide Disparity in Management Fees
Management fees can range from a low as 0.10% to more than 2% of AUM. This disparity in the amount of fees charged is generally attributed to the investment method used by the fund’s manager. The more actively managed a fund is, the higher the management fees that are charged. For example, an aggressive stock fund that turns over its portfolio several times a year in search of profit opportunities costs much more to manage than a more passively managed fund, such as an index fund that more or less sits on a basket of stocks without much trading.
Are High Management Fees Worth the Cost?
Active fund managers rely on inefficiencies and mispricing in the market to identify stocks that have the potential to outperform the market. However, the efficient markets hypothesis (EMH) has shown that stock prices fully reflect all available information and expectations, so current prices are the best approximation of a company’s intrinsic value. This would preclude anyone from exploiting mispriced stocks on a consistent basis, because price movements are largely random and driven by unforeseen events. Therefore, the EMH implies that no active investor can consistently beat the market over long periods of time except by chance. According to decades of Morningstar research, higher-cost actively managed funds do tend to underperform lower-cost passively managed funds in all categories.
Research by Nobel laureate William Sharpe has shown that, “After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar for any time period.” Sharpe concluded that active fund managers underperform passive fund managers, not because of any flaw in their strategies, but because of the laws of arithmetic. In order for active fund managers to beat the market by just 1%, they would need to achieve an excess return of more than 2% just to account for the average 1.19% percent management fee.
Hedge Fund Management Fees
Hedge funds charge notoriously high fees that have become controversial as performance has often lagged the market. Their fee structure is commonly referred to as "two and twenty" because it consists of a flat 2% of total asset value and 20% of all profits earned. Though the plan is often criticized, it has been the norm since Alfred Winslow Jones founded what is often considered the first hedge fund, AW Jones & Co., in 1949. As competition has increased and investors have become discontent, the standard has come under pressure, causing managers to often implement lower fees, performance hurdles, and clawbacks if performance is not met.