Incremental Fee-to-Value Test
Judge an active manager's extra fee against the extra return actually delivered
- Difficulty
- Easy
- Time to result
- ~days to results
- Steps
- 5
- Confidence
- 97%
The Incremental Fee-to-Value Test changes the denominator used to judge investment fees. A fee of one percent can sound small when stated as a share of assets, but the client already owns those assets; the service being purchased is investment return. First compare the active fee with the cost of a commodity index product. The difference is the incremental price of active management. Then compare that price with the incremental return the manager is reasonably expected to deliver over the market. Even a strong manager may charge many times the additional value produced, while an average manager who trails the market supplies no positive incremental value at all. This relative comparison makes the economic bargain visible and prevents a deceptively small asset-based percentage from escaping scrutiny.
Origin
Ellis described realizing during an investment committee meeting that fees were not inconsequential; measured against incremental active value, they were the central economic number.
Core principles
- 01Fees should be measured against purchased value, not existing assets
- 02A low-cost index is the relevant baseline
- 03Only incremental return can justify an incremental active fee
- 04Average underperformance makes the fee-to-value ratio indefensible
How to run it
- 1
Set the passive baseline
Identify a low-cost index product that supplies comparable market exposure. Record its all-in fee.
Pro tip Match the benchmark to the active mandate rather than using an unrelated broad index.
Watch out A weak comparator can exaggerate the apparent value of the active service.
- 2
Calculate the incremental fee
Subtract the passive cost from the active manager's total fee. This difference is what the client pays specifically for active management.
Pro tip Include additional layers of cost where they are known.
Watch out Do not stop at the headline management fee if other recurring costs apply.
- 3
Estimate incremental value
Estimate the manager's realistic long-term return above the market, not the total market return. Use evidence that accounts for the difficulty of persistent outperformance.
Pro tip Use a conservative long-run estimate rather than extrapolating a recent winning streak.
Watch out Past top-quartile results do not establish repeatable future excess return.
- 4
Compare price with value
Divide the incremental fee by the incremental return. Interpret the result as the share of added value transferred from the client to the manager.
Pro tip Also show the amount of incremental value the client retains after fees.
Watch out If expected incremental return is zero or negative, the ratio cannot justify the active fee.
- 5
Make the economic decision
Keep the active arrangement only when the expected client benefit remains compelling after its incremental cost and uncertainty. Otherwise choose the lower-cost baseline.
Pro tip Write the required excess return in advance so the decision rule remains stable.
Watch out Personal admiration for a manager is not a substitute for client value.
In the wild
Ellis compares an index costing ten basis points with an active service costing about one percent. The active premium is roughly ninety basis points. If an excellent manager adds only fifteen basis points over the market, the fee is several times the incremental return, leaving the manager with far more of the created value than the client.
→ A fee that appeared small as a percentage of assets becomes visibly large relative to the service's added value.
Common mistakes
Using assets as the denominator
Calling one percent small because it is only one percent of assets ignores that the assets already belong to the client. The relevant purchase is return.
Comparing fees with total return
The market return is available cheaply through an index. Only return above that baseline can count as the active manager's added value.
Extrapolating a winning run
Several strong years do not guarantee persistence. Mean reversion makes a recent record a weak basis for assuming future incremental value.
Is it for you?
Best for
It is best for investors and committees comparing an active manager with a low-cost passive alternative.
Not ideal for
It is not sufficient on its own when an active mandate supplies a distinct non-return benefit that must be valued separately.
From the transcript
“I have thought for years that fees were inconsequent I just realized they're the big number.”
“I already have the assets, so I'm not buying from you the assets I want from you the returns”
“the average manager actually gets beaten by the market over the long term.”
From the episode
CFA Charlie Ellis: Masters in Business (Audio)