Management Fee

What is a Management Fee?

A management fee is charged by a professional investment manager for managing an investment fund or portfolio. This fee compensates the managers for their time and expertise in selecting profitable investments and managing the portfolio. Management fees cover a variety of expenses including portfolio management, advisory services, and administrative costs, and is typically a percentage of assets under management (AUM).

Understanding Management Fees

Investment managers and financial advisors who manage client assets charge management fees, just as any other professional charges a fee for services.  In this case, services may include advice, expertise, and superior portfolio performance. The management fee is paid by investors to investment professionals in order to gain access to their expertise and resources. Investment professionals in return help investors with stock picking, allocating risk, rebalancing portfolios, and offering personalized investment advice.

The management fee also covers certain expenses involved with managing a client’s portfolio, such as fund operations and administrative costs. The rates charged as management fees vary significantly. Fees can range from 0.20% to 2%, depending mainly on such factors as management style and the size of the investment.

Management fees are usually lower for passively managed index funds, while active management carries a higher fee. In addition, institutional investors and high-net-worth individuals with substantial funds to invest may pay lower management fees based on the amount of assets under management. Management fees may also be called an investment fee or advisory fee.

Investors who do not wish to pay a management fee can choose to invest for themselves, eschewing professional investment management and advice. The investor may buy and sell stocks and create their own portfolio. Self-directed investing can be a very risky option for the inexperienced and they will have to consider commissions, brokerage fees, and currency exchange rates in addition to choosing stocks. Investment professionals capably carry out all of these responsibilities on behalf of investors in exchange for a management fee.

Low vs High Management Fee

Management fees can vary from as low as 0.10% to over 2% of AUM. The disparity in fees stems from the investment strategy implemented by the fund manager. Actively managed funds charge a fee more than passively managed index funds or ETFs. An actively managed fund that rebalances its portfolio several times a year costs more to manage than a passively managed fund like an index fund, which involves little trading and mirrors a particular index.

Active fund managers bank on inefficiencies and mispricing in the market in order to identify stocks with the potential to outperform. The expertise and time that goes into identifying these stocks is what drives management fees higher. However, according to the efficient market hypothesis (EMH), the current price of a security reflects all available information regarding the security and is a reliable indication of its intrinsic value. As a result, no market participant will be able to constantly exploit market inefficiencies since price movements are largely random and driven by unforeseen events. This implies that no active manager will consistently be able to beat the market over a long period of time unless there is some luck involved.

Actively managed funds charge higher management fees than passively managed funds but do not necessarily guarantee superior returns to investors. High-cost actively managed funds tend to underperform low-cost passively managed funds. After factoring in management fees, active fund managers fail to outperform passive fund managers. According to William Sharpe, for active managers to beat the market by 1%, they would have to realize an excess return of over 2% to account for the average management fee of 1.19%.

Management Fee vs MER

When discussing management fees, the term management expense ratio (MER) is usually included. There exists a subtle difference between the management fee and the MER. The management fee is paid to investment professionals who manage investments and is considered to be the operating cost of an investment.

The MER encompasses the management fees and the operational fees per transaction and is expressed as a percentage of the total fund value. That is, in addition to the management fees, the MER includes other costs such as legal fees, valuation, accounting, and taxes.

It is important for investors to understand the difference between management fees and the MER when making investment decisions and avoid unexpected fees. The MER is usually higher than the management fee as it includes other operating expenses as well.

Example

A management fee is charged as a percentage of assets under management. Assume an investor has $100,000 to invest and an investment firm charges a management fee of 0.45% per year. Every year, the investor will have to pay $450 for management. If the fee is charged quarterly, the investor will be required to pay $112.5 every three months.

Ideally, investors will enjoy an annual return from their investment that exceeds the management fee. This ensures that they can cover any related expenses linked to the investment and still realize a profit.

Conclusion

Management fees can be considered the cost of professional investment management. They are the norm in the investment management industry. Self-directed investing, which does not involve an advisory or management fee, can be complex, time-consuming, and risky. Investment professionals with the necessary skills, resources, and expertise are better positioned to manage an investor’s portfolio. The management fee varies depending on the investment strategy, and actively managed funds charging the highest rates.

MCQ – Management Fee

Below is a multiple-choice question to test your knowledge. Download the excel exercise sheet attached to find a full explanation of the correct answer.