What is a management fee?

A management fee is a compensation that is charged by an investment manager for their role in managing an investment fund. The investment manager is responsible for selecting the securities that make up the fund as well as the work they do in managing an investor’s portfolio. Management fees can also help funds cover operating costs that are not covered by other fees and expenses of the fund. The management fee is always paid by the investor. Examples of investment funds include mutual funds, hedge funds, exchange-traded funds (ETFs), and money market funds. Management fees are also called maintenance fees.

A management fee can be between 0.5 percent and 2 percent of the fund’s assets under management (AUM). This means that the investment manager for a mutual fund that holds $ 1 billion of AUM, can receive millions of dollars. An individual investor with $200,000 invested a fund could pay up to $4,000 in management fees.

The amount of a management fee is set by the fund. A money market will have among the lowest management fee. Mutual funds and ETFs can have maintenance fees that range widely based on the type of fund and the way the fund is managed. For example, an actively managed mutual fund means that the investment manager is actively trying to make sure the fund outperforms a benchmark index, such as the S&P 500. A passively managed fund, such as an index fund, is seeking to match the performance of an index. Because an actively managed fund will frequently turn over the fund assets in search of profitable trading opportunities, it makes sense that the actively managed fund may require more trading, and therefore result in a higher management fee.

A hedge fund, by contrast, has among the highest management fees. It is common for hedge funds to have a two and twenty fee arrangement. This arrangement highlights the difference between a management fee and a performance fee.

A management fee is completely separate from a performance fee. A performance fee is paid to an investment manager when, and if, the fund they are managing generates positive returns. A performance fee may also be called an incentive fee. However, an incentive fee is typically linked to a specific level of performance, such as having the fund outperform a benchmark index. The management fee is paid to the investment manager regardless of, and independent from, the fund’s performance. A management fee is considered an indirect cost because it is based on the assets under management (AUM) and not based on the performance of the fund.

It is common for hedge funds to set up incentive fees based on a hurdle rate and the fund’s high water mark. The high water mark is the highest value that an investment fund or account has ever reached. The hurdle rate is the percentage that a fund’s returns must achieve in order to charge an incentive fee. If a fund has both a hurdle rate and a high water mark, the fund must clear the high water mark and the hurdle rate in order for investment managers to collect an incentive fee.

By understanding the difference between a management fee and a performance fee, let’s take another look at hedge funds that have a 2 and 20 arrangement. In this arrangement, the fund charges a 2% management fee based on the fund’s AUM. The fund also charges a 20% incentive fee if the fund achieves a profit that surpasses a predefined benchmark. (NOTE: hedge funds are typically the domain of institutional investors. Most individual investors do not have the resources to participate in a hedge fund).

This is an ongoing debate among investment professionals. There is evidence to suggest that passively managed funds perform no worse, and in many cases, outperform actively managed funds. This is based on what is called the efficient market hypothesis (EMH). According to the EMH, a stock price fully reflects all the information that is available to investors as well as the analysts’ expectations for future performance. This hypothesis is in direct contrast to the role of the active manager who is looking to use market inefficiencies to select stocks that have the potential to beat a market or index.

In fact, because price movements are considered to be more or less random events, the EMH implies that an active manager cannot consistently beat the market over a long period of time. Nobel laureate William Sharpe conducted research and came to the conclusion that “After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar for any time period”. Sharpe went on to conclude that in order for active fund managers to beat the market by 1%, they would need to have returned in excess of 2% just to cover an average maintenance fee of 1.19 percent.

However, many investors still appreciate the benefits that can come from an actively managed fund - particularly younger investors who prioritize fund performance and are willing to accept the risk of losing money that comes with a more active and aggressive trading approach. Actively managed funds can also be attractive to inexperienced investors who don’t have the time or inclination to actively select their particular asset mix.

Nevertheless, when considering the total expense of owning a fund, a management fee is one of the most significant costs that can affect a fund’s performance. An investor needs to ensure that the fund’s performance is sufficiently making up for what they are paying in their management fee.

Management Expense Ratio (MER) -The management fee is not the same as the fund's management expense ratio (MER). It is, however, one component of the MER. A fund will also have operating fees that, together with the management fee, make up the MER. The MER includes, but is not limited to the following services and expenses:

• Administrative costs
• Marketing costs
• Employee salaries
• Legal, custodial and audit fees
• Research and analytic support
• Continuous professional portfolio management
• Costs associated with the regulatory commissions
• Fund valuation costs

As we mentioned above, the fee structure of a mutual fund or ETF is a significant expense for investors. The Securities & Exchange Commission (SEC) requires fund companies to list their fees in the fund’s prospectus. However, there is latitude to how they report them. To illustrate this, let’s look at this hypothetical example.

Company ABC reports a management fee of 0.35 percent and total annual operating expenses of 1.09 percent. Although the company does not directly call out their MER, it is fairly easy to calculate. In this example, you would add the management fee to the annual operating expenses to come up with an MER of 1.44 percent.

Trading Expense Ratio - In addition to the MER, a management fee does not include the cost of buying and selling a security inside the fund. This cost, although typically very small, is covered in the trading expense ratio (TER). Since this is a charge based on trading, the more actively traded a fund is, the higher this ratio will be.

Front-End or Back-End Load– Loads are sales charges that investors pay when they buy or redeem shares.

The investment manager is different from an investor’s financial advisor. For example, an investor’s financial advisor will help the investor choose their asset allocation and ensure that their overall portfolio matches their investment goals and risk tolerance. The financial advisor receives compensation for this service. However, this compensation is not the same thing as the management fee.

The management fee is paid to the investment manager of the particular fund(s) that an investor selects for their portfolio. One of the many benefits of participating in an investment fund is that the investor does not have to research or select the securities that make up the fund. That is the role of the fund’s investment manager.