At its core, finance is the art and science of coordinating the flows of capital to optimize returns and lower risks. The work of the financier is to find the best place for capital within a large system of interconnected markets, and the reward financiers get for that work is the fee.
Fees have a long history of being reviled, being both attacked in pre-capitalist western societies and being the focus of moralistic criticisms today. But the fee is simply the required incentive for an economic agent to produce something of value. That, of course, is warped by two phenomena; there are the free riders (those who pretend to produce something of value while not doing so, thus getting fees for free), and there are the eternal skeptics (those whose lack of total information in a market makes them falsely identify value added work as not adding a value at all). Both have caused significant misunderstanding and pressure in the financial sector, where fees are often attacked more viciously because the value one gets for those fees is abstract and hard to measure.
This has been a source of tremendous innovation, resulting in different fee structures. Long ago, the flat fee for a service was the standard, until a percentage of transaction value or profit was introduced. Then came the percent of assets managed fee—for instance, a fund managing a million dollars charing a 2% fee would extract $20,000 per year in fees. Percent of assets managed has fallen significantly since its first introduction and widespread usage last century, and the percent of AUM fee structure will tend to be proportional to the complexity of the asset class involved (a fund investing in CLOs will charge a much higher fee than an ETF investing in the S&P 500, for instance).
Sometime along the course of things, the percent-of-returns fee was introduced, with hedge funds famously pioneering the 2-and-20 rule; 2% of AUM was a flat management fee, with 20% of profits being an additional fee. This latter fee incentivized profit earning and resulted in fund managers’ interests aligning with investors. The percent-of-profits fee remains the staple of most actively managed funds.
Due to the fact that many active funds failed to outperform, some funds introduced the hurdle rate notion, saying that fees would be collected only after the fund achieved X returns. These could be structured in many ways using different time periods or standards (so the hurdle could be a straight positive return or could be a return above the index, even if that return was negative). Hurdle rates remain popular in some corners of the market, but are usually applied to performance-tied fees, with a standard fee to cover operational costs remaining fixed.
Finally, we should mention the decline in fees for passive funds, which have remained vanilla standard percentage of managed funds and have declined to tiny amounts—0.04% of AUM, for instance, for Vanguard’s big index fund (VOO). Fidelity pioneered the idea of the no-fee mutual fund (FZROX), with other companies following suit.
These low or no-fund fees have value for the retail investor world who is looking to gain exposure to the market for a long period of time, typically in a retirement account. But that does not mean (as some retail investors erroneously think) that the decline of fees is applicable or desirable for the entire financial world. The need for more complex funds, the use of derivatives, the specialized access to opaque markets means that there are corners of the world where higher fees not only remain the norm but are justifiable and serve an important part of the health of the broader financial world. And it is quite likely that more innovation in the ways fees work will provide even better financial products that will make the global financial system more interconnected, less risky, more robust, and much healthier.