Fixed Fee Funds Management: So Insane, It Just Might Work
I am rereading Blue Ocean Strategy by W. Chan Kim and Renee Mauborgne (I reviewed it here). Among other things, the book argues that spaces without competition can consistently be created by “service-isation” of commodity industries and commoditisation of service industries. It is an excellent intellectual exercise to imagine inverting certain industries. Can you make a service out of iron ore?
One such concept is the idea of Fixed Fee Funds Management, which has been floating around for years and seems so utterly without merit, that it just might work.
Traditional Funds Management
In traditional funds management, fees are paid as a percent of assets and deducted from an investor’s balance throughout the year. You might pay 1% of assets, or $1 per year for every $100 invested. There is typically an additional performance fee on top.
This structure is very financially attractive because it scales perfectly and has the potential for extremely high leverage on time. This also focuses the industry on the two variables of fees and performance, with both coming under increasing scrutiny in recent years. Whenever you find a fund that is able to extract higher fees for longer, you usually find that the intermediating variable is some combination of relationships (networking, brand, trust, social class etc) and distribution (getting in front of more investors). While important, these elements as an aspect of revenue generation are often overlooked due to the industry’s focus on fees and performance.
The downside of the traditional funds management approach is that levels of service and product features are not consistent across the industry and often there is a race to the bottom (race to the top, technically) on service provided. Why aren’t you writing a monthly letter, my other investment in XYZ does one? Where are your Youtube videos and your podcast?
The fee structure is so attractive to incumbents that it stifles innovation. It seems intuitive that a new entrant could charge a fixed fee, for example $25,000 a year, regardless of account size, and compete explicitly on price and service. However, the arguments against a flat structure are many and serious. Here are all the reasons I can think of why it wouldn’t work:
- Most industry costs (e.g. custodian, admin, brokerage) flex with account size. Fixed revenue and variable costs is extremely unattractive.
- The purchase decision of most funds is hidden because there is no up-front cost and fees are taken out without customers taking any explicit action.
- The inverse of this where you have to explicitly decide to pay $25,000 (or whatever) in return for a year of funds management is psychologically much more difficult
- Annual churn is lower at funds because there is no explicit purchase decision, just an ongoing arrangement with little customer involvement
- The financial rewards of a fixed-fee arrangement are much lower for the business operator
- Percentage fees scale perfectly to customer ability to pay (rich people pay more, poors pay less), which is not true in a flat fee model
- In the flat fee model, a few very large customers are a total waste of time because they max out capacity in your fund in return for trivial revenue
These are serious problems. But I think there is potential to reconstruct the product and create new market space where other participants fear to tread. Here is how I would go about it.
Fixed Fee Funds Management
Reconstruct the fee model. Instead of 1% a year for [whatever level of service is provided at that fund], make it explicit. You pay $25,000 a year and in return you get this type of investment approach, four investor letters, monthly holding statements, admin and custodial services and the annual tax summary.
(To be clear, I have plucked $25,000 from thin air for the purposes of this illustration, but rough numbers infer that’s around the level where you can operate a serious investment business; ~150 investors, ~$5m AUM each, ~$3m p.a. corp revenue. Notably, in this model a lot of small to medium size clients are much better than a couple of big ones)
There is a lot of work involved in funds administration and by explicitly re-presenting these as features, you can imbue them with the perception of value, whereas now they are boring and default. Second, the price model is very competitive for larger asset sizes and also explicitly freezes out small accounts, which greatly reduces the admin burden/cost of interfacing with 6,000 small investors.
Third, reconstruct the purchasing decision. It seems so obviously counterintuitive to charge $25,000 up front (instead of small fees deducted silently each month) that it just might work. You may be able to benefit from “mental accounting”, with investors paying from a “non investment account” and you being able to exclude those fees from performance calcs. Evil Genius laughter. (ASIC has entered the chat). Whatever, you would have to do some work here to figure out best how to get past those barriers to purchase. It’s pretty hard to pay $25k up front for a product you haven’t even tried yet. Maybe the silent fee is best.
Fourth, very few people are doing this and nobody else wants to do it because it would massively cannibalise their existing business, so you would have the space basically to yourself. No incumbent is ever going to try this.
Five, if you do this it needs to be all you do. Putting a fixed fee product alongside your other products just makes it look like a two headed stepchild and forces you into competing the same way as every other fund manager. You can have a suite of products if you like but they all need to be fixed fee with all the same features so that you can nail the messaging.
Lastly, this approach pretty much forces you into a mid- to mega- cap strategy, because you need to be able to invest upwards of $500m if you want to have a multimillion dollar business. However, it could work with as little as $100m and 20-30 investors if you run a lean ship.
The service of funds management is being increasingly commoditised, with attendant pressures on revenue and margins. Instead, I argue the service can be reconstructed as something different, with price innovation and features that people are willing to pay for.
Fixed Fee Funds Management. Food for thought.