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?

Manager Fees

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?

Errr what…?

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.

Guaranteed Outperformance

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?

Interested?

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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Why Consider?

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!