Management costs vs marketing costs

Last week’s Wall Street Journal had a short piece about the work of an exchange traded fund manager. While brief, it gives some obvious insight into why expense ratios for ETFs can be so much lower than those for traditional actively managed funds:

At 30 years of age, Hao-Hung (Peter) Liao leads a handful of portfolio managers at Van Eck Global who oversee some $24 billion in investor assets around the world. Mr. Liao’s rapid ascent—and the parallel success of his tiny team in handling its outsize mission—owe a great deal to the unique traits of the investments in which the team specializes: exchange-traded funds.

Such ETFs are easier to manage than index-tracking mutual funds. A single person or small team can oversee a long list of ETFs, as Mr. Liao and his team do. Indeed, 87% of Van Eck’s ETF assets are in the 38 funds run by Mr. Liao and his staff of three portfolio managers and analysts.

The difference between the cost of staff compensation for running $24bn in ETF assets and the much larger team needed to run $24bn in active assets isn’t going to be a make-or-break issue for expenses, but the fact that it can be done by just four managers and analysts shows how passive ETFs can hold down costs in every part of the chain (the article goes on to illustrate a few other places where the structure is more efficient).

That, of course, is good for cost-conscious investors – but it’s not the whole picture when it comes to costs.

Where every penny counts

By chance, I also came across an older article from Advertising Age discussing Vanguard’s approach to marketing at the same time. Vanguard is not a ETF specialist – although it runs ETFs – but rather a pioneer of index investing; however, like most ETF managers, low costs are a core part of its appeal.

Vanguard is an unusual company – it’s a mutual, owned by the holders of its funds, and so it has an exceptionally strong incentive to get the most out of its spending. This extends to how it measures the effectiveness of its marketing:

“We have to watch every penny we spend in any part of the business,” said Michael Ma, manager-head of retail advertising. “No business unit is given a pass.” Applied to advertising, that means everything is measured against its ability to deliver new households.

The company has taken smart, creative bets, finding ways to convey its message while still measuring impact—Vanguard often uses ad-specific web addresses and 1-800 numbers as a way of gauging effectiveness.

What’s relevant to people outside marketing is that while most investors typically think about the cost of funds in terms of the management and trading expenses, marketing and distribution costs can account for a huge chunk of the fees you pay.

For example, in the UK, the typical fee structure (pre RDR and platform review) is that funds have an annual management charge (AMC) of around 1.5%, of which 0.75% goes to the fund management firm, 0.25% goes to the platform and 0.5% goes to the financial adviser or discount broker.

So 0.75% of the AMC goes to intermediaries, much of it effectively being a payment for marketing and distribution services rather than real client administration costs. In the UK and many other countries you can cut down on this wastage by managing your investments through a cheap fund supermarket that rebates some fees to you, but many investors don’t.

Money squandered?

Even the 0.75% that goes to the fund management firm still needs to cover the firm’s own internal marketing and distribution spend as well as the actual cost of managing the funds. And while marketing expense can indirectly benefit fund investors up to a point – more assets under management equals greater economies of scale equals lower running costs per investor – much marketing expense is very obviously unsuccessful, as with BlackRock’s recent equity income campaign (FT article, may be paywalled):

BlackRock has seen disappointing sales in some equity income products, despite forking out an estimated $80m on its international marketing campaign.

The BlackRock campaign, dubbed ‘Investing for a new world’, kicked off in February and was rolled out across the world, costing an estimated $80m, according to media experts.

The US firm spent over €5m ($6.6m) in the first half of 2012 in the UK alone, and continued to invest considerable amounts on the campaign throughout the year. In October, it spent an estimated $1m in one day on newspaper advertising.

But despite the marketing efforts, the two most recently launched equity income products remain small, and two of BlackRock’s equity income products with longer track records still remain below the $100m asset mark.

By the end of October, the Emerging Markets Equity Income Fund had reached just $2.9m since its August 2011 launch, while the World Resources Equity Income Fund has accumulated $8.7m since April 2011, according to their latest factsheets.

In the UK – and more widely – much fund marketing is not viewed favourably by those outside the fund managers. It frequently gets criticised as weak, unfocused and too heavily dependent on kickbacks to the adviser and platform channels. A recent survey by Consensus Research had some choice critical quotes, of which this is a good example:

“It’s a woefully badly marketed industry. Totally unimaginative…[Inducement] that’s going to stop on the 1st January. And I think there are marketing departments all over the country who haven’t figured this out yet.”

Pay for management, not marketing

The relevant point for investors – as opposed to marketers – is to have a critical eye for why their funds carry the costs they do. Small differences in fund fees add up in the long run and while the extra overheads of active management can be worth the difference (albeit in a minority of cases), the same is not true of money wasted on ineffective marketing.

Not every fund manager should be as minimalist as Van Eck’s ETF management team, but ideally they would all have the same focus on expenses across the business as Vanguard. Unfortunately it’s hard to see that happening. But thinking about whether fees principally seem to be paying for management or marketing at any particular firm may give some perspective on whether they are likely to deliver any added value for money versus a Vanguard tracker.

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