Defining “Quality” is Always a Bit Difficult

As is likely the case with other liquid alts managers, we are sometimes asked the question about fee levels. Recently, we received such a question and went on to articulate what we thought was a well-reasoned position, only to receive feedback that our response was inadequate. Such feedback may be expected, so we thought we’d take another stab at addressing how to think about fees in the asset management world.

In business school many of us were taught that there are two generic strategies that a business can embrace, and if executed well, will increase the probability of success. Those generic strategies were high quality/high cost and low quality/low cost. To stake out territory somewhere in the middle is death, as the business has no identity in terms of either quality or price. While clearly an oversimplification, the basic concept rings true to us, and we think that this is playing out in real time between active and passive managers, and between financial advisors (the human kind) and robo-advisors.

Defining “quality” is always a bit difficult (and can drive you mad in the process if we correctly recall the plight of Phaedrus in Zen and the Art of Motorcycle Maintenance). But in the asset management business, we think most would agree that quality = alpha. Simple enough, except that alpha is itself a difficult concept. What we used to unquestionably consider to be alpha has increasingly been found to be systematic exposure to certain risk premia; a fancy way of saying “beta.” This epiphany came about as the data, tools and methodologies used in performance measurement all markedly improved over the last decade or so. Value, size, quality, etc. can all be harvested in fairly cheap ways, thus the rise of “Smart Beta.”

The result? Being an active manager has increasingly meant being under the gun; trying to convince investors of the existence of a discernable edge that can produce alpha with some consistency over time. And that is where the fee question becomes most relevant. No alpha? Better be cheap or you’ll disappear. Strong alpha after fees? Charge what you want (although don’t get too greedy; an alignment of interests with your clients is what builds a lasting business).

As is the case with any asset that an investor adds to a portfolio, it’s not the individual component that matters, it’s that asset’s contribution to the sum of the parts. And in the aggregate, the only question that matters is whether or not that collection of assets is able to generate the results required by the client. This sum of the parts analysis is inclusive of alpha (quality) and fees (cost). Many investors have come to the conclusion that either because alpha is elusive or ephemeral, or because the due diligence required to identify true alpha is too difficult, that they are better off with low cost investments. They’ve voted with their dollars, shifting hundreds of billions into passive vehicles. This is what an economist would call a “rational actor” looking out for his/her self-interest. We’d agree that the best course of action for most non-professional investors who aren’t using a financial advisor is to go passive, but some passive exposure makes sense as a part of any investor’s portfolio, sophisticated or not.

But we can’t lose sight of the fact that as is the case with risk exposures, the expenses of any one asset in the portfolio aren’t particularly meaningful. Further, cheap or expensive is always relative. Running a search in Morningstar for all index funds with a primary prospectus benchmark equal to the S&P 500 yields 169 funds (inclusive of all share classes), and the annual report net expense ratios on those funds range from two, yes two basis points (congrats Vanguard and Fidelity) to 231 basis points (name withheld to protect the guilty). In fact, there are 118 S&P 500 index funds with expense ratios exceeding 25 basis points. Point being 50 bps sounds cheap until you realize you can get the same thing for 10.

Further, if an investor believes, as we do, that active/passive is not a mutually exclusive decision, that embracing both can lead to the best outcome, consider the following. A simple portfolio of 60% S&P 500 (via SPY at 11 bps), 20% Barclays Aggregate (via AGG at 7 bps) and 20% in a managed futures fund (using the category average of 1.96% inclusive of all share classes), results in a total portfolio expense ratio of 47 basis points. I think most would agree that is quite a reasonable cost for a portfolio (and cheaper than many of the S&P 500 index funds that exist).

But again, the only reason you’d add that managed futures fund (or any active fund for that matter) is if it is truly additive to your portfolio. To justify a higher expense, an active strategy must either enhance return or reduce risk in a meaningful way, and the specific manager selected better be earning that fee by delivering true alpha.