—Old English maxim

Fees often become the primary evaluation tool for many trustees because they are the most easily discovered and dealt with in the few hours each quarter that attention is given to the portfolio. Accounting (adding and subtracting) is something trustees know well, while discovering and tracking skills and processes are not. There is sometimes also a bit of resentment at the levels of income possessed by these managers (especially when these managers are really arrogant about it). Then there is that F word—fiduciary. Many think that being a fiduciary is all, or at least mostly, about watching the checkbook.

Fees are important; there is no denying that. But the fees you see are not always the ones you end up paying. Investment managers are doing a significant amount of work and should be paid, even paid well, just not overpaid or secretly paid. Fees are important because both paying too much and paying too little will have an impact on your fund. Evaluation by the committee should not start and stop at the size of the fee, but on the value received. It is important that all the cost—observable fees, hidden fees and opportunity costs—be evaluated. One large brokerage firm (a new term is “investment bank,” a newer term is “wealth manager”) touts that it does not charge anything for the execution of share trades if you use its managers. Right, and “the check is in the mail” and “I’m from the government and here to help you.” You pay for everything, and if it is hidden you often pay too much.

An aside about fees, or more appropriately, expenses: if you are seeing a high turnover in your investment officers, you are either not paying enough or are hiring junior guys who leave when they have learned enough to step up to a bigger fund.

A word of caution here. The financial industry is the most dangerous place for the unknowing, the naïve, the incautious, the unaware, the gullible, the uninitiated. . . in other words, the average board member. This is not a place for part-time sailors; there be monsters, rocks and shoals in these waters. We don’t mean that it is rife with scams and illegality. Yes, they do exist, but the SEC has had a dampening effect, with some notable exceptions.

What we are cautioning you about are the common practices that either are not illegal or just can’t be found by regulators. The common assumption is that if you are on the investment committee for a large pool of money, you know what you are doing. This is not a place for learning about investments. Far too often, a person wants on the investment committee in order to learn about investments, and then learns they are not up to speed and turns to what the magazines, mutual fund sellers and personal wealth planers tout, which is a focus on fees.

Commissions, for example, are paid by the fund. Whenever your manager places a trade, the cost to the fund will range anywhere from a penny to four or five cents per share. The fund’s manager directs those trades, and when the trade is placed, the manager almost always gets a credit of some part of the commission to spend almost however he wants. These are called soft dollars, and are legal, but are, in my opinion, just not right. This is not what you want to happen. Those are the fund’s moneys, so if you want to pay for the manager’s “research,” or equipment, go ahead. But if not, don’t and make the manager pay for it out of their fees. After all, isn’t that what the fees are for? How to do so is simple: require that the manager use a broker that will rebate those excess commissions to you, not to them, or who will simply charge much less. The fund’s consultant or investment officer will know how, but the committee must make sure they do so. Many consultants and some investment officers just want to be friends with the manager, hoping for more business, or not wanting to confront the manager. If the commissions are zero, look hard at the trade execution price—you may be paying more than you should.

Charging a commission to investments traded net (profit, fee, and commission already built in), or cutting the visible commission and then trading principal at a higher price, are just two ways to take a little more. This is common with some of the “discount” brokers who charge a fixed fee or low commissions, then trade at a price much higher than the volume weighted average price of the day.

One investment manager practice, which was used in the past and probably still is, is charging a full, undiscounted fee and then each year the investment manager will write a large donation check back to the foundation. Not a kickback per se, but isn’t it nice to do business with such a generous patron of the organization? The foundation couldn’t fire this guy, he donates so much, right? This is different than the typical arrangement, where the investment managers will simply discount their fee from the beginning. Although the managers are charging (net) the same total dollars for their investment management services, the manager who writes the big donation check each year is given more leeway when it comes to performance because organizations just can’t quite give up that “donation.” One manager in Texas made a career and loads of money doing just that.

There is a corollary to this approach that does not involve donations, but social access, where the committee will accept higher fees or lower performance because of some “benefit” of access to the board members of other foundations, or the advisory board of the manager, or maybe it’s just that expenses-paid “conference” held each year at Disney World in February.

Private equity and hedge funds are prime examples of fees that do need to be controlled. The long/short hedge fund manager that charges “2 and 20” and then delivers 5% net should be fired (hung if it were legal).. It is unconscionable that someone would charge, much less pay, that much in fees for so little in return. If they returned you 25%, maybe. For many like this, it did not matter that these funds had a history of single-digit standard deviations. In 2008 they lost as much as any long-only fund, then gated so their clients could not get their money back.

Private equity managers often charge their fee on the total you have committed, which means you are paying fees on money you have not yet invested. Their argument about needing the revenue to employ good help holds water for the first and maybe second fund of small general partners, and while we don’t like it, we can live with it. For established general partners, they should be charging on deployed capital only. There are pressures now in the industry to bring those “2 and 20” fees down to more reasonable numbers. Always remember they are negotiable, and your consultant should be negotiating.

An important part of the investment function is the evaluation and control of fees. This is not the only function, nor are you required to take the smallest fee. The whole no-load mutual fund and index fund industries have been built on the premise that the best investment is the cheapest one, and free is best of all. It is far too easy to focus on the obvious price and miss the cost. Price is short term, and cost will go on for a much longer time. What is, or at least should be, important to a governing board is what the institution gets, not what the investment manager gets.