(Bloomberg View) — When I open an account at a bank, I get charged the same fee whether I put in $100 or $10,000. This makes sense, since it doesn’t really cost the bank much more to hold $100 for me than to hold $10,000.
But if I invest $10 million in a mutual fund, I’m typically going to pay 10 times more than if I invest only $1 million. This is because the mutual fund charges a percentage fee. Part of that fee goes to pay for the fund’s administrative and marketing expenses. But part of it is simply called a management fee or an investment advisory fee. It is just a percentage cut that the fund takes out of my investment every year. Typically, this fee is about 0.5 percent to 1 percent. Financial advisers also typically charge a percentage fee based on the assets they oversee.
When money managers charge percentage fees, it means that the price you pay for having your money managed goes up when you have more money to manage. Why does this happen? Does the cost of managing money really scale linearly with the amount of assets under management, so that it costs 10 times as much to manage $10 million as it does to manage $1 million?
For hedge funds, highly active mutual funds, private equity and venture capital, this might actually be the case. Many hedge fund strategies show dramatic outperformance with small positions, but when the positions get large, transaction costs quickly overwhelm the “alpha” (market outperformance). Similarly, it may be difficult for private-equity and venture- capital firms to find more than a certain number of high quality deals. For managers like this, whose strategies don’t scale up, it might make a lot of sense to charge percentage fees.
But most mutual funds, asset managers and financial advisers don’t use these high-alpha strategies. Most are very diversified, and they invest your money in broad asset classes and in many different stocks or bonds. For these low-alpha money managers, whose main services are risk management, diversification and convenience instead of alpha, costs almost certainly don’t go up by a factor of 10 when the amount of assets under management gets 10 times bigger. (Although big clients do often get discounts, especially from financial advisers.)
So why the percentage fee? I have a theory. I think it’s a form of price discrimination.
Here’s the basic economics. Every customer has a maximum amount that she is willing to pay for some good or service. This is called her willingness to pay, or WTP. If the price of a washing machine is $500 and your WTP is $1,000, you got a great deal, while if your WTP is only $510, you didn’t get much of a break.