For a large part of the 1980’s, 1990’s and the early 2000’s, hedge funds were equated with enormous financial success. Serving as investment vehicles primarily marketed towards the wealthy, hedge funds use a plethora of aggressive investing strategies in an effort to generate outsized returns. These strategies worked very well for the funds and for their clients for a short while. Yet, as the Securities and Exchange Commission (SEC) began to change the rules and monitor the actions of these funds more closely, the hedge fund game changed forever.

In 2004, hedge fund managers were required to register their operation formally with the SEC and tie their name to that of their firm. This was mainly intended to keep portfolio managers accountable as fiduciaries. Then, after the global financial crisis in 2008, lawmakers in Washington D.C. took more decisive action to protect domestic financial markets. The Dodd-Frank Wall Street Reform Act of 2010 passed and brought with it more significant regulations to the United States’ financial sector. The restrictions on hedge funds were far more severe than what happened in 2004, such as extensive screening of investors and the presentation of sensitive data on trading positions. Because of the more stringent regulations, the risks that hedge funds once were able to take became almost impossible. Most notably, the Volcker rule has been placed into effect, which placed higher restrictions on speculative investments and proprietary trading that do not benefit the customers of funds.

The success of the exchange-traded-fund (ETF) blossomed. ETFs are low-cost funds that track market indexes, asset classes, or commodities and are publicly traded like stocks. There is a stunning cost difference between ETFs and hedge funds. Hedge funds require a significant amount of active management and they usually charge a two percent annual management fee and a 20 percent fee on all profits (aka “two and twenty”). ETFs, however, charge anywhere between less than one and six percent on the basket of securities. Additionally, ETFs have the potential to attract the same clientele that hedge funds have traditionally won over: high net worth individuals. With high tax efficiency and low fees, ETFs are a no-brainer for high net worth portfolios.

Understanding their advantageously low costs and taking into account the massive losses hedge funds incurred during the crisis, ETFs became a very desirable investment vehicle. Following 2008, total account balances in ETFs grew at an exponential rate and have continued to grow at an enormous annual rate of around fifteen percent compared to that of hedge funds’ annual rate of around nine percent. This past summer marked a big milestone for ETFs because total account balances for ETFs over took total account balances for hedge funds.

Assets under management (The Economist)
Assets under management (The Economist)

What this highlights above all is a shift in demand from active to passive investment management. In recent years, active investment managers have seen large fluctuations in their ability to beat passive funds. Ben Johnson, Morningstar’s director of global exchange-traded-fund research notes that “more than anything, fees matter” when seeking compounded capital gains.

The theoretical debate on whether passive or active investing is truly more advantageous in the long run has been going on for quite some time at this point. First, we must discuss Modern Portfolio Theory (MPT). MPT dictates that investment diversification should play a complimentary role. Indeed, each investment in a given portfolio should play off the successes or failures of other investments to maximize return. MPT teaches us that there is a possible combination of assets that assumes very little risk and comparatively large return. This is all well and good, but one of the main assumptions of MPT is information efficiency and that is where the theory gets tricky. Given efficient markets, then all known factors will be priced into different stocks making it nearly impossible to beat the market in any case. Information asymmetry, the exact opposite as information efficiency, is actually the case, the effort, let alone the capital, necessary to achieve the proper asset diversification that mitigates a significant amount of risk and generates sizable returns.

With the facets of MPT in mind, we can now begin to weigh in on active and passive investing aspects. Active investors assume more financial risk when trying to beat market indices, but passive investors take a significantly lower amount of risk when riding along with the successes or downfalls of markets. While the difference in returns of these two investing styles can be enormous, it is often enough that active investors, in fact, find themselves unable to generate returns that properly justify their assumed risk.

Active vs Passive Performance (Forbes)
Active vs passive performance (Forbes)

What is so specifically important about the ETF versus hedge fund account balance trend is that when it comes to assuming financial risks, most investors don’t seem to really want to make double-digit returns when it means that their losses could be of equal magnitude. Kenneth French, Finance Professor at the Tuck School of Business at Dartmouth College, has commented extensively on the chance of investors doing better than indices. Indeed, Professor French’s Efficient Market Hypothesis (EMH) postulates that in the indefinite long run it is impossible to beat the market without acquiring high-risk investments. It would appear that the people are beginning, more so, to agree. Even if beating the market is possible in the short run, it takes effort. Stretching that effort into the long run and observing that beating the market is nearly impossible, it would seem that the effort is not worth it.

ETFs are here to stay for the long-term. As more people want to find a cost and effort-effective way to participate in the markets and gather sizable returns, the more popular ETFs will continue to grow.

The financial services industry, after stealing the spotlight during the recession, is now making headlines once again. In response to recent regulatory legislation, banks nationwide have made the controversial decision to hand consumers a whole slew of new banking fees, namely a monthly charge for using debit cards.

The announcement has since ignited a public uproar, as exasperated consumers, who are still suffering from the aftermath of the financial crisis, have no intentions of welcoming the new additions to their monthly statements.

The new federal legislation that sparked this chain of events, known as the Durbin Amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act, more strictly regulates the financial services industry. More specifically, the Federal Reserve now prohibits banks and credit card companies with assets over $10 billion from charging merchants more than 24 cents for processing each purchase made with a debit card.

By contrast, these banks charged retailers an average fee of 44 cents per debit card transaction prior to the new legislation. Although such a cap on interchange fees may not seem like much, it will collectively cost banks $6.6 billion in annual revenue.

By limiting the amount that banks and credit card companies can charge retailers on debit card purchases, the government ruling attempts to encourage competition and to counter the current monopolistic tendencies of the financial services industry.

However, banks have proven unwilling to accept such a substantial reduction in revenue. Still reeling from the financial crisis as well, banks like Bank of America have developed an ingenious way of thwarting the government’s attempt to slash their profits: pass the burden down to consumers. Through charging a monthly fee for debit card purchases, banks nationwide have been able to generate a new source of revenue that can counteract the Federal Reserve’s cap on interchange fees.

The larger trend of instituting a debit card fee includes even the most prominent banks. Bank of America, the nation’s biggest bank, recently announced its decision to charge a $5 monthly fee for debit card use.  Bank of America joins a growing list of financial firms that have already done the same. Other national banks, including Wells Fargo and Chase, are piloting $3 monthly debit card fees.

By instituting a $3 fee, Wells Fargo estimates it could recover over $200 million, which would partially offset the regulation’s impact. Similarly, regional banks like Regions Financial and SunTrust will be charging a $4 and $5 fee, respectively.

The most recent debit card charge is just one of several frustrating fees implemented by banks in an effort to recoup the revenues lost to legislation. Government restrictions have caused banks like Chase to now charge customers for paper statements, checking accounts, and even for online banking. In some regions, Chase levies a $15 charge for checking accounts, which is in addition to ending its debit rewards program. Bank of America is also considering applying the new debit card fee to customers who engage in automatic payments, such as monthly cable bills, gym membership fees, or car payments.

Others, like USAA Federal Savings Bank, have managed to abstain from charging such fees, but do so at the cost of having to end its debit rewards program. Citibank has avoided the fee too, though it decided to raise its monthly charge for basic checking accounts by $2. TD Bank and Bank of America now charge their customers $2 and $3, respectively, for using non-network ATM’s. Similarly, HSBC raised its ATM fee for customers using non-HSBC machines from $2 to $2.50, and is also charging a 35-cent debit card transaction fee per use.

Moreover, a string of banks have also raised the requirements necessary to qualify for services like free checking accounts, in order to amass more income in the form of fees.

The most recent legislation, while noble in theory, was accompanied by a series of unintended consequences that severely undermine its efficacy. On the one hand, the Durbin Amendment assists small businesses and retailers, by alleviating some of their financial woes.  These merchants, who are still struggling due to diminished consumer spending, aren’t passing down any of the savings to consumers, though. In doing so, merchants enjoy a reduction in costs as well as a boost in their own profit margins.

Meanwhile, consumers become the victims, and are made considerably worse off. They are left to bear the brunt of the policy’s financial repercussions, without seeing a decrease in prices. Unwittingly, the extra burden is transferred to the very people whose spending and investment have the potential to boost economic growth and put America back on its feet.

These $5 debit interchange fees, when considered collectively alongside the other new charges already put into place, will have a significant impact on consumer spending habits. In addition to being extremely irritating and exploitative, the accumulation of these additional fees will result in an unnecessary reduction in a household’s disposable income. In a time where stubborn unemployment is still an issue and households are struggling to make ends meet amid the current volatility, this disincentive to spend can considerably inhibit economic growth and recovery.

More importantly, because debit cards have become relatively more expensive, consumers will likely seek out cheaper alternatives.  However, at the moment, there doesn’t appear to be many viable options.

The inconvenience and cost of constantly using ATMs, especially out-of-network ones, coupled with fee-ridden checking accounts may cause consumers to more heavily rely on the use of credit. Doing so will likely cause a rise in household debt, particularly for those with bad credit.

The shift back to using credit rather than debit or cash could potentially be very dangerous given the current economic conditions. Furthermore, according to some estimates, the higher fees and minimum balance requirements will bring about a forced exodus of as many as 1 million low-income consumers from the banking system. Desperate for other options, a large proportion of this group will likely turn to check-cashers, credit unions, and other financial providers.

While the culprit in all of this may seem obvious at first, identifying the true perpetrator is actually more difficult. Contrary to what many consumers may believe, financial institutions should not necessarily be held entirely accountable for the spike in fees.

Yes, in an ideal world, large banks should simply accept the regulatory action and cope with decreased revenue and lower profit margins. However, in a capitalist system where firms seek to maximize profit, it can be reasonably expected that banks will lessen the financial burden by seeking new avenues of income, just as the airline industry did by charging for checked baggage. Despite what consumers are led to believe too, banks may be justified in charging high fees, in order to protect themselves against fraudulent transactions. Due to the increased restrictions, banks like Chase may have no choice but to limit debit card purchases to under $50 or $100.

America today suffers from a sluggish economy that features low consumer confidence and an unsustainable budget deficit.  Thus, in such a tenuous situation, the responsibility lies in the government’s hands to mediate all of this. The government must assume the role of overseer and ensure the more equal distribution of financial burdens during this critical stage of economic recovery.

Small business owners and consumers alike are not in secure enough positions to absorb the added costs. Thus, each segment of society must compromise and concede certain temporary sacrifices in order to benefit the greater society, such that it stimulates economic growth in all sectors in the long run. The government must also be more aware of the complexity and interconnectedness of the financial system. As shown by the extensive ripple effects stemming from this one government decision, policymakers need to more carefully assess the potential impacts of economic revitalization attempts prior to implementation.

There needs to be greater reform in the interchange network, mainly in the relationship between large banks and retailers. Under the current system, payment networks like Visa and MasterCard have managed to charge retailers processing fees that greatly exceed the actual cost of processing a transaction. According to some estimates, margins on these charges can reach as high as 400%.

Curiously, the processing fees are comparable to those in other countries, and yet the United States has one of the highest interchange fees in the industrialized world. In an effort to establish a more equitable financial burden, the financial services industry must endure lower margins, but not to the extent the Durbin Amendment calls for.

Additionally, the government must address the fallout and inequities from the new legislation. The financial services industry has evaded the cap by instead raising charges on lower-value purchases. Thus, the payment structure is such that some retailers actually endure higher fees for small-dollar transactions than they do for bigger purchases.

The government must also somehow induce retailers to lower their prices so that savings can be passed on to consumers, in order to induce greater consumer spending.  This can be accomplished either through some sort of subsidy program, by granting retailers some sort of tax incentive to do so, or by modifying the fee structures put into place by the new legislation.

Overall, the government needs to orchestrate more adjustments to break up monopolistic markets and inject a greater degree of competition into the flailing economy, so that small businesses do not continually fall victim to the larger players in the industry.

The effects of the legislation aren’t all bad, though. Consumers ultimately choose the lowest-cost provider, which could potentially galvanize the industry into having more competitive pricing schemes. Some have already withdrawn their money from banks to avoid their fees, in search of a cheaper alternative.

In theory, the market will eventually reach a competitive equilibrium that features banks charging more reasonable fees to consumers and retailers alike, which would be highly beneficial for economic stability. However, in reality, as evidenced by the repercussions from the Durbin Amendment, the expected outcome is not always realized.