There is much talk in today’s investment circles about a possible new economic era, one where low growth rates – and low investment returns – may be the new normal. In such a world, low overhead would become a key factor in determining portfolio allocations – a market opportunity that would benefit low-fee “efficient” funds.
In fact, entrepreneurs have led a movement toward lower-priced funds that has been underway for years. Price competition across the financial services sector began with discount brokerages like Schwab, and then got more intense with index funds and inexpensive online trading. More recently, we’ve seen the advent of exchange traded funds (ETFs), funds that, like index funds, have extremely low expenses and are designed to replicate the performance of an asset class by tracking a benchmark like the S&P 500. This entrepreneurial movement toward lower fees on investment funds continues to gain traction.
ETFs Are Now Surpassing Hedge Funds in Assets Under Management
The conventional fund management industry – i.e., mutual funds – first pursued “active” strategies in an attempt to beat the market. Hedge funds, aimed at the wealthy and big institutional investors like pension funds and university endowments, use even more complicated strategies designed to gain higher returns or better risk management. But the simpler, cheaper strategy of index funds and ETFs seems to be winning. As of June 2015, assets in the global ETF industry were near $3 trillion, surpassing hedge funds, according to ETFGI, a research firm, and Hedge Fund Research.
Hedge funds, for all their fame in the 1990s, have had a deteriorating record of late. In the first decade of the 2000s they managed only three years of returns of double-digit returns, and in this decade there has been only one.
This is hardly the type of performance that merits high fees. Hedge funds typically charge a 2 percent asset management fee, and a 20% “carry” profit interest in the overall profits of the fund. A pretty deep reach into investors’ pockets…
Real Estate — Will Non-Traded and Private REITs Soon Be Dinosaurs Too?
In real estate, the modern era has seen REITs be the primary investment vehicles. Many investors use publicly-traded REITs, since their liquidity seems reassuring. Others, though, prefer non-traded (but public) or private REIT products which are often sold through independent broker dealers.
Non-traded and private REITs can be expensive, though. Front-end fees can include selling compensation and expenses of up to 10% of the investment amount, as well as other offering and organizational costs categorized as “issuer costs.” These fees can, in the aggregate, represent up to 15% of the total offering price – which is a significant drag on performance. But even recent regulatory moves against non-traded REITs haven’t yet had a significant impact; non-traded REITs continue to produce high commissions for broker-advisors.
There doesn’t seem to be any evidence, though, that non-traded and private REITs are buying properties more cheaply, or managing them more efficiently, than the numerous other investment vehicles through which investors can invest in real estate. As with hedge funds, these private REITs may simply be a very expensive way of buying into widely available assets.
Entrepreneurs are Changing Real Estate Fund Cost Structures
Part of the disruptive effect of the new wave of real estate crowdfunding companies is that fees are significantly lower than many other real estate investment vehicles. RealtyShares, for example, charges investors only a 1% asset management fee on its various real estate equity investments – and a similar 1-2% servicing fee on debt and preferred equity investments. While the project sponsor typically pays a commission to the broker-dealer that raises financing for the project, it is typically a fraction of the 10-15% expense load of a private REIT.
Lower costs aren’t the only entrepreneurial innovation being introduced. Crowdfunding companies also tend to utilize the same pass-through investment structures as larger institutional investors, which are designed to fully take advantage of the various tax benefits available through direct ownership of real estate. These pass-through entities (like LLCs) not only avoid double taxation but also may allow their members to obtain greater tax benefits compared to REITs through loss carry forwards and pass-through tax incentives. Depreciation and interest expense deductions can make this advantage quite significant.
Real estate has historically been a bit of a laggard in financial innovation, but all that may be changing soon. Entrepreneurs finding ways to lower the fees typically associated with private real estate investment opportunities are likely to strike a chord with investors. History shows that high-priced alternatives often fade away once the marketing spin has receded and investors realize only average return rates. Transparency – and low fees – offer a decidedly better bet for the future of investment services.
A similar version of this article was earlier published in Forbes.