A Prickly Fact about Fees: Some of the Best Investments Are Expensive

Few tenets of conventional investing wisdom are considered as unassailable as the notion that when choosing mutual funds you don�t get what you pay for.

John Bogle, the founder of Vanguard Group, built a reputation and a huge business by convincing the retail-investing world that most of the stock-pickers who operate actively managed funds aren�t worth the fees they charge. He proved that the majority of stock pickers fail to outperform the stock indexes they�re trying to beat. It�s now taken for granted that most investors are better off putting their money into funds that track a stock index and charge rock-bottom management fees.

Naturally, it�s become a habit of investors everywhere to fret over mutual fund expense ratios and the cost of hiring a financial advisor to direct you toward the best funds. Since most actively managed funds underperform, investors figure the fees they charge are a pointless waste of money. They believe that funds with higher expense ratios are more likely to lag the stock indexes.

I�ve long suspected that this concept is lazy and wrongheaded, or at least greatly exaggerated. Most of the high-net-worth clients my firm advises invest a significant chunk of money into hedge funds and other alternative investments. Some of these are extraordinary performers and most charge hefty management and performance fees. Shouldn�t the ordinary mutual funds that the rest of us can afford also charge higher fees?

After all, doing good research�really digging in to understand the opportunities out there�costs money. And in any business, the best, most talented performers should be able to charge more for their services. Thus, I�ve been pondering a hypothesis for a while now: Some of the best investments are also the most expensive.

I recently asked Erik Olson, the head of quantitative research for my firm�s investment committee, to test my hypothesis with a thorough quantitative analysis.

Erik�s analysis revealed that a lot of poorly performing actively managed funds do charge high fees, much higher than the index funds and exchange-traded funds that they were intended to beat. In fact, the funds with the lousiest returns sometimes even carried higher fees than the other actively managed funds competing among the same asset classes.

But guess what? Erik�s research also confirmed my hunch: The fund managers who post the best returns generally charge higher fees all around; they charge far more than index funds, and they beat the passive funds� pants off in making money for their investors. And sometimes their fees were even higher than those charged by rivals whose performance was poor.

What does it all mean? It does not mean, of course, that we should hand over our savings to whichever fund manager charges the highest fees. It means that, if we want to outperform the markets, we will probably have to unlearn our habit of obsessing over expense ratios. We�ll have to find better ways of separating the good performers from the bad. And if we find top-notch mutual fund managers, we should expect to compensate them well.

I don�t think all hedge funds are a good bet, but in that world, the correlation between high fees and high returns can be particularly strong. Steven Cohen�s SAC Capital Advisors commands what are probably the highest fees in the business. His investors forfeit 3% of their total capital per year plus 30�50% of the funds� profits to Cohen for the privilege of allowing his firm to manage their money. And what a privilege it is: SAC returned an average of 16% per year�after all fees�over the past 10 years. That�s among the best of all hedge funds and vastly superior to the S&P 500, which returned negative 0.43% over the same period. Put another way, SAC�s cumulative value increased by 500% in the past decade; the S&P�s lost 5% of its value.

In the hedge-fund world, this is not that surprising. All hedge funds charge relatively high fees�commonly, 2% of assets and 20% of profits. Fund managers can invest in virtually any asset class; greater choice puts a greater premium on analysis and insight. So, institutional and high-net-worth investors are willing to pay handsomely for the services of the best-performing managers.