Are portfolio management fees a rip-off? Compared to what?
It's easy for financial professionals to "beat up" on portfolio management fees. After all, it's possible that it doesn't feel like you're getting much value for what you're paying?
Let's suppose that you have a million dollar portfolio. One percent (1%) of a million dollars is $10,000 that is charged each and every year! That's a lot of money! Granted, the more in funds you have in assets under management (AUM), the less your total fees will be because of pricing breakpoints.
When we look at links that purport to evaluate fees (like this one), there isn't any other measurement to look for quality: https://larrybates.ca/t-rex-score/
So, are the fees... worth it? If so, how can we measure?
Putting aside the fact that outsourcing your portfolio management to a trusted advisory firm helps you free up your own time and leverages the minds and resources of others (which is never free), let's just look at the numbers and some simplified statistical analysis.
There is a statistic in Modern Portfolio Theory that is measured in all mutual funds. It's called R-squared. I will quote from Investopedia the key takeaways on what R-Squared means:
In investing, R-squared is generally interpreted as the percentage of a fund’s or security’s price movements that can be explained by movements in a benchmark index.
An R-squared of 100% means that all movements of a security (or other dependent variable) are completely explained by movements in the index (or whatever independent variable you are interested in).
If the R-squared metric is interpreted as the percentage explained by the movements in the index... what would the inverse of the R-squared metric be?
The inverse of the R-squared metric would be "the talent index", meaning the amount of movement attributable to the investment management of that particular fund.
If an R-squared metric is reported at 85... then 85% of the results in that fund is attributed to the index movement. The remaining 15% is then attributed to the portfolio management.
The lower the R-squared metric is... the more the returns are generated by the portfolio management.
The question is... in a managed portfolio by most investment firms (Registered Investment Advisory firms), do they have that calculation as mutual funds do?
Way back when I sold retail mutual funds, I liked two particular funds from American Funds: American Funds Capital Income Builder and American Funds Capital World Growth & Income.
At the time when I was selling them, the Capital Income Builder fund had an R-squared ratio of around 45 - 50. Capital World Growth & Income had an R-squared ratio of about 85. If we look at the inverse of these funds, the Capital Income Builder fund had a "talent ratio" of about 50-55! The Capital World Growth & Income fund had a "talent ratio" of about 15. Today, we can look up these funds at Yahoo Finance and look at the risk tab.
Capital Income Builder currently has an R-squared ratio of 87.96.
Capital World Growth & Income currently has an R-squared ratio of 96.73. Clearly these funds are relying more on the market for their returns than their portfolio management than they used to years ago.
Does that mean these are bad funds? No, that is not what I am saying. All that I'm saying is that not every portfolio is made up the same and not all portfolio management fees are bad. The only question is... how are we making our decisions?