Asset diversification isn't a free lunch anymore as high fees eat into profits
Research based on JP Morgan capital return data finds that management fees on asset classes are very high relative to their diversification benefit
Just as in the taverns where "free lunches" began, investors hoping to get something for nothing by diversifying are drinking much of the profits up in the form of fees paid out to managers.
Or more properly, losing most of the "free" on rounds investors buy for the house.
Since Nobel Prize winner Harry Markowitz first coined the phrase in 1952, diversification, with its ability to enhance portfolio returns while suppressing volatility, has been acknowledged as the "only free lunch" in investing. Though the benefits of diversification in theory are not in question, the actual gain depends on how much an investor pays to access a given asset class.
When it comes to paying for active management, even large institutions often give up half or more, William Jennings and Brian Payne, of the US Air Force Academy, say in a new study.
"The fees on diversifying asset classes are astonishingly high relative to their diversification benefit," Jennings and Payne write. "Diversification is often spoken of as the only free lunch in investing, yet we show that it is not free and is properly considered only in light of its costs. More exotic asset classes typically come with higher investment management fees, which offset their diversification benefits."
The study looks at the alpha, or outperformance, generated by the various asset classes into which investors can diversify and then compares that to the fees charged by actively managed products or managers in those asset classes.
