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.
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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, financialstatements 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 thisextends across any business, financial or otherwise: Truly great businesses havepricing power. That means they can raise prices, or at least control prices, to some extent. For example,if Warren Buffett tomorrow stepped down fromBerkshire Hathawayand said, "I'm going to raise a $5 billion stock fund and become a hedge fund manager again," he would have no problem findinginvestors at 2% and 20%, thetypical fee structure. I bet he would even have a line out the door at 3% and 30%. There's actuallya company by the name ofRenaissance Technologies, it runssomething 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, whileinvestment fees are generally coming down, goodasset 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. Andpart of the reason for that trend toward lower fees is actually in an alternative assetmanagement 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 theautomatically generated nature of these. Companies likeVanguardare pushing for lower fees,because it doesn't make sense in a lot of cases for anS&P 500 ETF, for example, to have a 1% management fee. That doesn't make sense. You'rejust taking all the companiesthat 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 thatconsumers have the internet, they can just go and see what the fees are on other funds, and be like, "You know, I'mnot going to pay 1% when I could pay 0.5% for this other fund."
Wathen:It'sthe 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 andtake the 0.25% extra return. No one isgoing 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 justtaking more and more share for that reason.
Lapera:Yeah,which is why I, as we circle back toalternative asset managers, they are able to charge higher fees -- because in theory, they're making more than the return on theS&P 500.
Wathen:Right, they'regenerating superior returns, and they're alsoworking harder for it. Oaktree, when it takes a distressed debt fund andstarts raising money for it and then starts investing in it, they'regoing to have to go through bankruptcy courts, all this stuff,to take control ofthese companies. It's a long slog. It takes money and capital and geniuses tofigure out these opportunities. So,that's what you're paying for, in theory.
Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends Oaktree Capital. The Motley Fool has a disclosure policy.