From soda companies to hedge fund managers, of the best indicators of a business's quality is its ability to control the price at which it sells its goods or services. As low-cost funds continue to collect hundreds of billions of dollars in assets with each passing year, fund managers that are charging above-average fees for below-average performance are at risk of having to cut prices or lose assets to lower-cost alternatives.
In this segment from Industry Focus: Financials, join The Motley Fool's Gaby Lapera and Jordan Wathen as they discuss the importance of pricing power in fund management fees for investors who own shares of asset management companies.
A full transcript follows the video.
This video was recorded on April 24, 2017.
Gaby Lapera: We talked a little bit about what alternative asset managers are, how they make money, different revenue streams, things that should look good on their income sheet, income statement, balance sheet, 10-K, 10-Q, financial statements in general. Is there anything you would look at and be like, "This is a huge red flag for an asset manager"?
Jordan Wathen: I think this extends across any business, financial or otherwise: Truly great businesses have pricing power. That means they can raise prices, or at least control prices, to some extent. For example, if Warren Buffett tomorrow stepped down from Berkshire Hathaway and said, "I'm going to raise a $5 billion stock fund and become a hedge fund manager again," he would have no problem finding investors at 2% and 20%, the typical fee structure. I bet he would even have a line out the door at 3% and 30%. There's actually a company by the name of Renaissance Technologies, it runs something called The Medallion Fund. It's the most legendary hedge fund of all time: It charges 5% on assets, plus 44% of returns. The fees are ridiculous, but the returns are so good, no one cares. If you earn 20% after fees, you don't care what the fees are, it just doesn't matter. So, while investment fees are generally coming down, good asset managers should be able to hold the line, or at least slow the ...
Lapera: The free fall?
Wathen: ... the trend toward lower fees.
Lapera: Yeah. And part of the reason for that trend toward lower fees is actually in an alternative asset management adjacent field, which is the ETFs and the mutual funds and the index funds. You're seeing fees go down really fast in those areas because of the automatically generated nature of these. Companies like Vanguard are pushing for lower fees, because it doesn't make sense in a lot of cases for an S&P 500 ETF, for example, to have a 1% management fee. That doesn't make sense. You're just taking all the companies that are in the S&P 500 -- you're not guessing or anything -- and putting them into an index fund. So, I think you're seeing this widespread fee lowering. The other thing is the power of information. Now that consumers have the internet, they can just go and see what the fees are on other funds, and be like, "You know, I'm not going to pay 1% when I could pay 0.5% for this other fund."
Wathen: It's the exact same thing that's going on in traditional asset managers. If a mutual fund manager could promise me they were going to beat the S&P 500 by 2% a year, I'd happily pay 1.75% a year in expenses and take the 0.25% extra return. No one is going to complain about that. But if the returns aren't there and you're charging a higher fee, you won't be in business very long. And ETFs, and all these passive funds, for that matter, are really just taking more and more share for that reason.
Lapera: Yeah, which is why I, as we circle back to alternative asset managers, they are able to charge higher fees -- because in theory, they're making more than the return on the S&P 500.
Wathen: Right, they're generating superior returns, and they're also working harder for it. Oaktree, when it takes a distressed debt fund and starts raising money for it and then starts investing in it, they're going to have to go through bankruptcy courts, all this stuff, to take control of these companies. It's a long slog. It takes money and capital and geniuses to figure out these opportunities. So, that's what you're paying for, in theory.