Fund Price Wars: A Dollar Auction Game

Asset managers are always competing for assets of individuals, institutions, and retirement accounts. In 2018 alone, asset managers gave up more than $3.5 billion in fees by reducing the expense ratios they charge for their products (Warren Miller, 2019).

In Miller’s publication “The Game Theory of Fund Price Wars”, he explains the cost-cutting situation with the Dollar Auction, a game that illustrates a paradox of rational choice theory.

How a Dollar Auction works?

Two players are given opportunities to repeatedly bid in an auction for a dollar bill. The player with the highest bid wins the dollar bill. The catch is that the second highest bidder must pay his or her highest bid as well. When player A bids 1 cent, he will take into account if player B bids 2 cent, then he will lose 1 cent for nothing. In other words, whenever one player offers a higher bid, the other loses.

When the bid is up to 1 dollar, the bidder will have neither profit nor loss. But, if another player offers $1.01 bid and wins the dollar bill, he will only lose 1 cent instead.

People typically start this game by calling out a small amount of money because they figure they have little to lose. They think to themselves, "If I can win a buck for 10 or 15 cents, I'm pretty smart." The problem is that everyone else in the game has the same logic. When the bids approach 1 dollar, the motivation of the bidders change: from a desire to maximize returns to minimizing losses. Thus, the question transforms from "How much can I win?" to "How do I keep from losing?" At this point, the auction often goes above $1.

Funding price wars are much like the dollar auction. The players (asset management companies) are bidding (by making fee cuts to their funds) for dollars (asset flows) repeatedly. And of course, nearly all asset flows go to the cheapest funds within any given category.

Figure 1: Total net flows by net expense ratio percentile within category

over the last 5 years for passive funds

Investment fees have dropped so low but is this the end? No, if the dollar auction model holds true. Fund companies may soon be paying investors to invest with them.

Who wins the price wars?

In the dollar auction, the auctioneer wins – receiving more money than auctioning the dollar bill. Likewise, the end investor is the winner of the fund price wars.

Although no asset manager wins a price war, some may lose less. Firms that create differentiated products are equivalent to potential bidders in the dollar auction who refuse to make an initial bid. They don’t allow themselves to be sucked into the game. Instead, these fund managers maintain their pricing power by offering hard-to-replicate investment.

Reference:

1. Warren Miller (2019), The Game Theory of Fund Price Wars www.flowspring.com

2. Douglas Noll (2000), The Dollar Auction Game: A Lesson in Conflict Escalation www.mediate.com/