Fees Eat Diversification’s Lunch

Although diversification is often spoken of as the only free lunch in investing, the authors show that it is not free and that it must be considered in light of its costs. They also show that fees on diversifying asset classes are high relative to their risk-adjusted diversification benefit, with the more exotic asset classes carrying higher price tags. Because there is meaningful cross-sectional variation, fees need to be considered when making strategic asset allocation decisions.The summary was prepared by Derek W. Johnson, CFA.What’s Inside?The authors critique the widely quoted phrase that diversification is the only free lunch in investing by looking at the “true” alpha generated by asset classes and the fees associated with investing in those asset classes. They examine asset classes with regard to their allocation alpha, which is the alpha derived strictly from the asset class and not from market exposure. They refer to an editorial by Charles Ellis, CFA, published in the May/June 2012 issue of the Financial Analysts Journal (FAJ), that showed that active investment management fees are astonishingly high. The authors also incorporate the work of Martin L. Leibowitz and Anthony Bova, CFA, published in the July/August 2005 issue of the FAJ, that showed that exposure to the US equity market is a key driver of portfolio risk and identified the allocation alpha as the true alpha independent of US equities. Building on these two previous articles, the authors examine the relationship between allocation alpha and fees. They find that the bulk of the excess return based on allocation decreases significantly when fees are applied. This decrease is more pronounced for exotic asset classes, such as hedge funds, private equity, global bonds, and narrow mandates in public equity. Once fees are subtracted from allocation alphas, the true benefits of diversification into non-US equities are reduced significantly for most investors. The authors conclude that some asset classes should not be used, whereas others should be given lower weights in a diversified portfolio depending on the type and size of the investors and the fees they are able to negotiate.How Is This Research Useful to Practitioners?Diversification is one of the hallmarks of wealth management. But understanding the costs and fees versus the benefits of diversification is important for investors. The authors point out that fees are undergoing heightened scrutiny by large pension plans. They also note that diversification in some asset classes comes with added risk. Investors should assess whether the added risk is worth taking given the allocation alpha after fees.The authors examine the split of allocation alpha between investors and active managers for different diversifying asset classes. Because many managers use relationship pricing, the authors advise small investors who want to lower fees to consolidate funds and have larger accounts with fewer managers. The authors also look at the allocation alpha after fees on passive investment vehicles, such as exchange-traded funds, and find that fees still lower the allocation alpha but not as severely as with active management.The authors identify some important practical implications. For example, investors should ensure that fee levels are part of the asset allocation decisions. In addition, it is usually unwise to separate asset allocation decisions from manager selection and investment vehicle decisions. How Did the Authors Conduct This Research?The authors use two data sources for their research. They use J.P. Morgan’s “Long-Term Capital Market Return Assumptions: 2013 Estimates and the Thinking behind the Numbers,” which is a publicly available report on asset class risk, return, and correlation assumptions covering 45 asset classes and is updated annually. They narrow the list to 11 asset classes that are typically used in diversified portfolios. To examine fees, the authors use the biennial fee survey from Callan Associates, which is a major institutional investment consulting firm with more than $2 trillion in advised client assets. They examine actual and negotiated fees for three investor types that vary in asset size and fee level: an average small endowment, an average state pension fund, and a high-quality foundation that would benefit from the lowest fees.Abstractor’s ViewpointAlthough diversification is one of the most important aspects of managing risk in a portfolio, it should not come at the expense of added fees, especially if the fees consume most if not all of the benefits. The authors build on a growing body of literature that examines fees with respect to alpha in general and true or pure alpha in particular. Their work should help investors assess the true benefits of diversification, especially with regard to the more exotic asset classes.Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.Authors’ note: The opinions expressed in this article are those of the authors and do not necessarily reflect the opinions of the US Air Force Academy, the US Air Force, or any other federal agency.