Do you use Vanguard like me? What do you like about them? Is it the user-friendly interface, range of products or customer service?
Nah! It’s coz they’re cheap – right?
They provide market-performance tracking funds at a super low level of fees. For example, you can get exposure to US equities for 4bps. That’s really a very low cost product. And everyone loves something of value that’s cheap – am I right?
But you know what’s better than cheap? Zero cost – right?
Well, yeah, I guess. Zero cost is certainly better than low cost. But zero cost ain’t gonna pay the bills for these poor impoverished money managers. They’re not going to get that place in the Hamptons with a zero fee fund. So it’s a nice idea, but it’s not going to work my friend.
And you know what’s better than zero cost?
If they pay you!
Yeah, I guess, but I really don’t think these investment firms are charities and won’t be giving out handouts any time soon. So I wouldn’t hold out any hope of that.
But consider this new idea.
Have you read the important notes? It’s a condition for reading this blog.
A New Idea
An actuarial firm (yay for actuaries!) has proposed a new way for investment management firms to charge for their products. Currently there is a huge amount of discussion in the industry around investment management fees. In particular, whether the investment manager or the consumer should bear the risk of under-performance of an actively managed fund.
Previously there has been little incentive for investment firms to change the cost structure of funds, but in recent years there has been a flood of money exiting actively managed funds into passive funds, like Vanguard. As a result, the investment management industry is being forced to re-evaluate their value-add and how they charge for that.
Now I know what you are thinking. You’re no fool. After all, you’re a reader of this blog; so you already possess superlative taste and canny powers of discernment! You are not falling for the industry hype of shooting the lights out with stellar returns. You know that’s so often a losing bet and you’re quite happy to stick with your Vanguard funds.
But what if a manager guaranteed you outperformance versus the market?
I bet, but it requires a mental shift for both investors and money managers.
Firstly imagine that the money manager guarantees you at least a return in line with the market (i.e. a passive return). However, in addition the manager will also pay you a sum simply for holding your money.
In return, you allow the manager to keep all returns they can generate above the market returns.
In investment-speak – you are guaranteed the passive return plus a pre-determined alpha, and the manager keeps any excess performance, and you are protected against under-performance.
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Let’s look at what’s in it for you and the manager.
For the investor you get a guaranteed return in line with the market plus an additional sum. In other words you are getting guaranteed outperformance versus a passive fund. That’s pretty good, and there would be no reason not to do this. Given the choice between a purely passive Vanguard fund and this product then you would always choose this new fund.
The manager gets to eat their own cooking. If they can truly beat the market then they get to keep all the returns above the market performance. This could be extremely lucrative if the manager’s performance is greater than the index, but in the event that the manager under-performs the index then they suffer a loss.
It has to be said that this pricing model has not been met with a rush to adopt. Managers are taking on additional risks and will suffer a direct revenue loss if they under-perform the index. Given the current model where they are paid a fee whatever their performance, then any change would be resisted.
Consumers are giving up some potential upside performance, but in return they get a guaranteed return in excess of the index and are guaranteed not to under-perform the index. So it’s like a zero-fee Vanguard fund with additional guaranteed return.
In essence you, as the investor, are being paid by the manager to hold your money. In return you are receiving a return in line with the market plus a margin. This is not a new business model when you think about it. Banks pay you to hold your money; it’s called interest on your checking account. Corporations will pay you to hold your money; its called interest received as a creditor, or stockholder return as a holder of equity. So providing capital should be rewarded in the market, and it’s only really the investment management industry where they get away with taking your capital and being paid to do so.
Would you abandon Vanguard for a fund like that? As a provider of capital in the markets do you think you should receive better compensation? Are you a money manager and want to comment on this? Comment below – and thanks for visiting!
13 thoughts on “Would you abandon Vanguard for a money manager who provided this?”
Never heard of this. Still trying to find it – what is the catch?
I think the catch is the firm guaranteeing your return going bankrupt.
There could be a real risk of that if they are swinging for the fences and underperform the market. Since they have to make good losses.
For the investor you give up any outperformance in excess of the guarantee (which might be small).
If the manager didn’t go bust then this arrangement should always be a good deal for a passive investor as (fees aside) you will always receive the market return + x. The economic effect from an investor perspective should be similar to a cut in annual management charges.
As hinted above, most actively managed funds may struggle to offer such a fee structure in the long term as they would go bust when the markets took a downturn.
That’s a good way to think about it. It’s like getting a cut of the annual management fee. There is a tension with the manager in taking risk. They don’t want to underperform the market but also don’t get paid unless they outperform.
But really, that’s how it should be…
I can’t see a money manager being able to afford to do this. Great in theory and for the investor.
I think you’re right!
I’d sign up if they also provided bankruptcy protection. It would never happen IRL.
In a similar train of thought I always thought a realtor should be paid based on price sold above a baseline. Charging 5-6% of overall sales price is crazy!
OMG don’t get me started on realtors!
I already use an adviser and I make more money than the typical Vanguard investor even paying the management fee, WHICH IS NOTHING LIKE 1%. I also have more safety. I don’t make a lot more but thus far I’ve done better over the long term cost adjusted. I don’t use typical actively managed funds per se’ but I use DFA funds which use the efficient market investment theories of Gene Fama and Ken French Nobel winners. My portfolio also uses ARQ funds to add specific balances to my risk management. My portfolio is designed around the efficient frontier and I have multiple independent non correlated assets in correct portions so I run even with the market return but at about 2/3 the market risk.
The Vanguard portfolio is easy, cheap, functional and completely amenable to DIY, but it is sold as BEST. It is not best by a log shot. It is merely easy and adequate. It caries far more risk than a correctly adjusted efficient frontier portfolio. In 2008 the S&P dropped 50%. My efficient frontier portfolio dropped 38%. The local high just prior to the 2008 crash was in Oct 2007. It took the S&P till April 2013 to recover it’s October 2007 value. My lower risk portfolio had recovered by the last half of 2011 and by April 2013 was 18% ahead of the S&P 500. My portfolio is also more bullet proof to SORR compared to the S&P and on that basis alone is worth it’s cost.
The described free alpha scenario is actually pretty easy to accomplish. Just write covered calls on the index, and possibly buy a few puts for insurance and if you actually know what you are doing you can trade the VIX as a hedge. Or you can use the index as collateral to be levered and used in momentum trades or long-short trades, straddles and strangles and spread positions etc. I have funds that use these vehicles in my portfolio using ARQ funds. I’m happy enough with my quant based management, but I’d readily use the free alpha funds if I was convinced the traders new their asses from their elbows and practiced strict risk management and trading rules. I used to trade commodities and over time if I could win 2 out of 3 trades I made a lot of money but that took a lot of work and access to a seat on the exchange. You couldn’t do it reliably from a computer screen Over time the fund would create pile of “insurance money” to be used to payout screw ups and after that the delta between promised alpha and delivered alpha would become monster gravy for the investing company, which is their objective. Another name for this technique might be called “the poor man’s Goldman Sachs.”
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