The financial services sector of the US economy grew from 4.9% to 8.3% of GDP from 1980 to 2006, a disproportionate share of which came from an increase in asset management fees. In 1980, $26 billion of equities was actively managed. By 2010, that figure had increased to $3.5 trillion, an increase of 135 times. Economies of scale should have been well achieved throughout the asset management industry, but expense-to-assets ratios actually increased over the period. The author studies whether the increase in asset management fees has led to excess active management returns and also whether such costs may have been required to improve the efficiency of the market.

The author seeks to determine whether the increase in asset management fees since 1980 has been useful either in the sense of increasing returns from active management to investors or in that such costs have benefited investors in low-cost passive index funds by improving price discovery and market efficiency.

On the surface, economies of scale should exist in asset management because most costs are fixed, such as those for portfolio management, marketing, legal capabilities, and security analysis. But these costs should make up an ever-smaller percentage of total assets as funds under management expand.

But the author finds that actively managed funds have consistently underperformed passive index funds by an amount equal to the difference in fees between the two funds. Total expenses paid to equity mutual fund managers increased from $170.8 million in 1980 to $24,143 million in 2010, which is an increase of 141 times and larger than the growth in fund size. He also finds that average returns of active funds for a 20-year period through 2011 were lower compared with the benchmark indices across large-cap and small-cap equities as well as fixed income. In addition, arbitrage opportunities to obtain excess risk-adjusted returns did not appear to be available during the study period, which suggests that there was no change in market efficiency.

The author offers several possible explanations as to why excessive management fees persist. One possibility is that consumers may incorrectly associate the quality and effectiveness of management advice with price or are otherwise influenced by deceptively framed advertisements. Overconfidence may also be a factor if investors believe they are able to consistently pick the best investment managers.

The author’s period of study is mainly 1980–2006, and his focus is on the asset management industry in the United States. Data for the study come from Lipper Analytic Services, Greenwich Associates, Standard & Poor’s (S&P), CRSP, and Vanguard.

Expense ratios (asset management fees as a percentage of assets managed) for the period from 1980 to 2010, encompassing both index and actively managed funds, are examined. The author finds that expense ratios for all equity funds grew 66 bps from 1980 to 2010, which was mainly attributable to active funds because active funds as a proportion of equity funds dropped from 99.7% in 1980 to 70.9% in 2010. In addition, the average fees for actively managed equity and fixed-income funds increased from 1996 to 2011.

As to whether the increase in management fees can be justified by the value added to managed portfolios, the author finds that for the 2007–11 period, S&P benchmark stock indices outperformed major US equity funds by 62%–83% and Barclays benchmark bond indices outperformed major US fixed-income funds by 61%–96%.

Investors who choose active managers with expectations of outperformance may be overpaying for returns that fail to keep pace with benchmark indices. A better alternative for investors is to allocate assets to passively managed funds. The passively managed funds industry has certainly grown in the last decades in terms of transparency and breadth of product offerings, which should lead to better cost savings for investors.