In the days of the old when Stock Broking was carried out in a ring with people shouting at one another, brokerage as a percentage made eminent sense.
Buying 100 shares was far easier than buying 10,000 shares for example. Percentage of fees made sense since a higher effort was required to buy such huge quantities while at the same time trying to get it for the best possible price for the client.
Once we moved to the computerized mode and we did that once NSE came into existence, this should have gone out of favor but it did not.
In fact, one of the reasons I became a broker was the attractiveness of the fees.
Placing an order for say 100 shares in the new environment took me as much effort as it was for placing an order for 1000 shares but the magnitude to the income was 10x, 100x if you consider a client who wanted to buy 10,000 shares.
Once online brokerages came into being, this should have vanished since now the client himself did all the work and the broker had nothing to contribute regardless of the size of the order and yet it did not.
It took Zerodha to shake things up starting in 2010 but even today, that is not the norm.
In the world of investing though, it’s been a percentage fee all the time even though the effort to manage your money of say 10,000 isn’t very different from the effort to manage another person’s investment of 1,00,000.
The higher the investment, the more the impact of fees is observed. And you end up paying more in absolute terms even though there is no real difference in the way you are handled vs the smaller guy.
While we have an order-based brokerage and flat fee advisory, we are yet to come across any fund that charges a fixed fee and why should they anyway.
The barrier to entry is high and one that ensures not every Jill can become a fund manager and even if he does, unless he can showcase good performance over a long time, money ain’t going to flow and the high-cost structure makes it a non-feasible venture right at the start.
When the mobile revolution started in India, one needed to pay approximately 24 rupees per minute for every incoming and outgoing call. This fell as competition rose and the number of subscribers grew.
Today, we are accustomed to pretty much free outgoing and incoming once you have paid a fixed fee.
Also Watch: The Impact of Fees on Your Investment Returns
What the Cable guys used to charge and continue to charge as is the case with say a DTH operator or OTT networks like Amazon Prime or Netflix charge is based not upon how much you use or not use but based simply upon a fixed fee.
I may watch them on a 21-inch television or project them on a large screen, watch them for an hour once in a way or watch them continuously for days – the fees are the same.
A few Portfolio Management Service companies offer a zero management fee but charge a percentage on performance. On the face of it, this seems ideal – I make money only if you make money.
His fee structure was simple – Zero Management Fee, a 6% hurdle rate, and 25% of the profits above it.
This has been copied by many others though with one unique distinction. Most of them aren’t Warren Buffett.
In the years he managed the partnership’s, he had not one negative year. This even in years when the S&P 500 had a negative year. In 1966 for example, the Dow closed with a loss of 15.6% while Buffett generated a positive return of 20.4% for his clients.
How many such fund managers are around these days anyway.
To encourage equity investing, talking heads regularly talk about how the long-term returns for the Indian market are 15% never mind the fact that Sensex was not even there let alone investable during the star period.
But overall, the assumption is that you should get around 12% for the investments you make in equity.
The question is not whether you need to pay a fee and given that we don’t really have a choice in terms of Fee-only Investment Products vs % fee-based Investment Product, such a question adds no value either. But it’s about whether you are getting value for the fee you pay.
If a fund performed in line with the markets, should you pay 0.05% or 2%? Depending on your investment capital, this can run into lakhs of Rupees – not something that should be taken lightly or ignored.
A very well known fund manager recently posted his long term track record of 15 years and it’s impressive.
If you had invested say a Crore of Rupees with him when he started, the value of the said investment today would have been before fees worth nearly 14.40 Crore. Post a small 2.5% fee levied year after year, this drops to just below 10 Crores. A 30% cut in the profits.
The returns are still better than if you had invested in Nifty 50 (Total Returns), so maybe this is okay or is it.
As an investor today, you have no clue as does the manager whether he will provide you with an Alpha say 10 or 20 years away while the only guarantee is the fee you pay.
Much of the personal finance space about savings is dedicated to saving on small things that bring joy to our lives but would barely make a dent when it comes to the long term.
There are plenty of stories of how instead of buying a Royal Enfield bike you had invested the same in the stock, you could have afforded a Merc maybe.
Of course, most of them don’t use LML Vespa (a fairly nice scooter back in the days as an example) since if you had invested in the shares of LML instead of buying that scooter, your value of the investment today would have been Zero.
From a personal point of view, I think it’s important to save where we can and spend where we must.
So, why do we pay? Are investors really that ignorant about the impact of fees on their final returns?
The reason we pay is not that we are generous but because we expect better returns than the market. In a world or market where data cannot be gathered, this could hold true – we don’t know what we don’t know.
But we are in an interconnected world and data to back the fact that not only does fees eat deeply into long-term returns is out there but we have sufficient data to show that very few fund managers after accounting for survival bias are even able to beat their benchmarks.
So, why do we pay? Is it Greed or is there something else? Why do funds that have massively under-performed their benchmarks continue to get new investors to bet that the “Worst may finally be over”. Is it Behavioral?
Our Goals are 20 / 30 years out and fees we pay can have an extraordinary impact on the final capital we aim to reach but one that is less discussed and even lesser talked about.
One reason passive indexing is picking up so much is not only because they are cheap but also because most funds don’t really provide a differentiation that makes the fee worth paying.
A fund that is a closet index has no reason to charge anything more than what a passive fund should and yet most closet funds (and the number of such funds will only go up in time) are happy to charge for the Beta while ignoring the impact it has on the Alpha.
As I finished writing this, I stumbled upon this
Cover Image: ET