Profits in Finance

By James Kwak

Noah Smith on one reason why financial sector profits have remained high as the industry has grown:

Why haven’t asset-management charges gone down amid competition? In a recent post, I suggested one answer: people might just be ignoring them. Percentage fees sound tiny — 1 percent or 2 percent a year. But because that slice is taken off every year, it adds up to truly astronomical amounts. … If many investors pay no attention to what they’re being charged, more competition can’t push down those fees.

I think that’s basically right, but there’s a smidgeon more to it. Expense ratios on actively managed mutual funds have remained stubbornly high. Even though more people switch into index funds every year, their overall market share is still low—about $2 trillion out of a total of $18 trillion in U.S. mutual funds and ETFs. Actively managed stock mutual funds still have a weighted-average expense ratio of 86 basis points.

Why do people pay 86 basis points for a product that is likely to trail the market, when they could pay 5 basis points for one that will track the market (with a $10,000 minimum investment)? It’s probably because they think the more expensive fund is better. This is a natural thing to believe. In most sectors of the economy, price does correlate with quality, albeit imperfectly. It’s also natural to believe that some people are just better than others at picking stocks, just like Stephen Curry is better than other people at playing basketball. Finance and economics professors can talk all they like about nearly-efficient markets, the difficulty of identifying the people who can generate positive alpha, and the fact that you have to pay through the nose to invest your money with those people (like James Simons), but ordinary investors just don’t buy it. And this is one area where I think marketing does have a major impact, both in the form of ordinary advertising and in the form of the propaganda you get with your 401(k) plan.

So while some people are no doubt ignoring the fees, others are probably saying, “Sure the expense ratio is 100 basis points, but look at the past performance!” (Anyone who makes decisions based on past performance—that is, most people—is taking fees into account to some extent, since published mutual fund returns are almost always net of fees.) So the persistence of high fees is partly due to the difficulty of convincing people that markets are nearly efficient and that most benchmark-beating returns are some product of (a) taking on more risk than the benchmark, (b) survivor bias, and (c) dumb luck.

9 responses to “Profits in Finance

  1. This is a very good read for the roots of our problems.

    http://www.planetaryhq.com/rapeamerica.htm

  2. I think both you and Noah are missing the reason, a bit. Most people that I know who have investments in high-fee funds, actually have no choice. The people I know in this situation are participating in these funds through their 401K plan, and their 401K plan offers only high-fee funds. Myself, I’ve worked at more than half-a-dozen companies over the last 25 years, both large companies and small companies, and in only ONE of those situations was there even a single low-fee fund available.

    With 401K plans, employees have no choice to go outside the funds offered by their plan. If their plan offers only high-fee funds, their only alternative is to forego the 401K plan entirely, which is a far worse choice then enduring the high fee.

  3. Just an FYI to those with 401K – the fine print is that no matter what your financial situation is at the time you NEED what is in the 401K, the IRS will find ways to collect taxes on it. Tax laws are being revised explicitly to undo the “laws” in place that herded you into the 401K in the first place.

    Meaning that forgoing the 401K might not be the far worse choice considering the risk that the future will have new tax laws addressing the 401K.

    I know of what I speak.

  4. The censors are compassionate on this website – and it is a good reminder that indeed many cases of mental illness are not being addressed.

    GWB has not been the President for – how many years now?

    Sad.

  5. Yes, Annie, which is why there is no hope for this country, If a problem can’t be solved politically during the course of three 2 term administrations, it can’t be solved politically. If a solution is to exist, it shall arrive from outside of politics, taking the political structure and everything within it’s orbit along with it.
    And not a moment too soon I might add, cause when the psyco Dr. has or is the mental illness, he can’t and won’t provide the cure to his own illness, it must come from an outside source, so riddle me this, where could that source come from/? A most unlikely and surprising place indeed, if we only knew i’m certain the Dr. would have it removed so he can’t or won’t be threatened, am I right or am I right?? Yes, I am swimming in a sea of right.

  6. Higher depends on the reference though, individual investing, broker managed, or indexing, and even indexing can be mangled by investors.

  7. Mike Gladish

    Regarding Bryan Pendleton’s comment: You’ve hit the nail on the head! Also, I have no “line item” on any of my 401k statements or on-line that shows me exactly, each month, what I have been charged in fees by the plan administrator(s). If these fees were called out in statements for plan participants, there might be more questions asked or more concern on most people’s part.

  8. R.I.P. you

  9. Great blog, global economy is very important.