June 6, 2012

Figures Don’t Lie. Well, Actually, Sometimes They Do

Like most folks my age, I find much of today’s “totally awesome” language just as brain-dead as the “happenin’-groovy-far out” expressions we used to think were “cool” when we were kids. There are some exceptions, though, and one of them is the response “Really?” Possibly the best term to come out of pop culture in 50 years, “Really?” pretty much says it all when one is trying to express their disbelief that whatever they just heard is really the best that someone could come up with. 

Which, of course, makes it pretty darn useful in today’s culture. For instance, take the comment by “daveinphoenix” to my May 30 blog, about publicly disclosing conflicts of interest, in which “dave” (if I may be so informal) expresses his outrage at the “huge” 1% AUM fees that some advisors charge. Truth to tell, my response should be “Really?” and just leave it at that. But since that doesn’t fill up a whole blog, I’ll elaborate. 

Dave seems to hang his outraged hat on data he says was released by the Attorney General of New York a few years back, showing that “over a 10-year period, a 1% asset management fee = a 9% front-end load if a mutual fund has no increase in market value,” which he writes is “1% to the 10th power.” 

Really? Sorry, couldn’t help myself. Let’s tackle the math first. 

Now, I was no math major myself, but at my liberal arts college, they did make us take some basic arithmetic (lest we miscount the number of credit hours we needed to graduate), and by my calculations, 1% to the power of 10 would be .01 x .01 x .01 x .01 x .01 x .01 x .01 x .01 x .01 x .01, which my calculator tells me equals .00000000000000000001 or .000000000000000001%. Since that’s a pretty darn reasonable AUM fee, even for say, Donald Trump, I think we can conclude that’s not what Dave meant, and that Dave wasn’t a math major either. 

The other part of his argument suggests that he also wasn’t an economics major: A 1% annual fee over ten years is the same as a 9% sales load? Really? Oops. If this analysis makes sense, why stop there? Why not point out that a 1% fee over 100 years equals a 90% load? How outrageous is that? Boy, those billionaires who pay their private bankers an AUM fee sure must be stupid.

This is what we philosophy majors call a reductio ad absurdum: taking an argument to its ridiculous conclusion. The flaw here, as any good economist (such as Stephen Levitt, author of “Freakonomics”) would tell us, is reducing the benefit of paying AUM fees vs. commissions to merely the dollars involved. It’s the same flawed logic that encourages people to pay off their mortgages to “save” the hundreds of thousands of dollars in interest that they would have paid to those “greedy” bankers (which makes economic sense only if you couldn’t find anything more profitable to do with your money than your after-tax mortgage rate). 

In this case, the faulty presumption is that the recipient of, say, a 5% sales load (the alternative to the annual AUM fee) would be satisfied with his or her upfront commission for the following ten years; while all he has to do is change mutual funds once, and his wife is driving a new Mercedes—and the AUM fee suddenly isn’t looking so bad.

As Freakonomics shows us again and again, to understand the economics of a situation, one has to look for the financial incentives, and the risks they create. Sophisticated investors don’t pay AUM fees because they are, or might be, cheaper: they do it because fees reduce the incentives for their advisors to act contrary to the investors’ best interests. Perhaps this will come as a surprise to Dave—and to the New York Attorney General—but people will pay extra for that kind of peace of mind. If they don’t, it’s not because they want to save a few bucks. It’s because they don’t understand the reality of the situation. Seriously. 

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