Measuring the True Cost of Active Management by Mutual Funds

Jul 5th, 2006 | Filed under: Investment Management Fees | By:
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By: Ross Miller, State University of New York (SUNY) Albany
Published: August 2005

Recent years have seen a dramatic shift from mutual funds into hedge funds even though hedge funds charge management fees that have been decried as outrageous. While expectations of superior returns may be responsible for this shift, this article shows that mutual funds are more expensive than commonly believed. Mutual funds appear to provide investment services for relatively low fees because they bundle  passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in closet or shadow indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index. This article derives a method for allocating fund expenses between active and passive management and constructs a simple formula for finding the cost of active management.  Computing this active expense ratio requires only a fund’s published expense ratio, its R-squared relative to a benchmark index, and the expense ratio for a competitive fund that tracks that index. At the end of 2004, the mean active expense ratio for the large-cap equity mutual funds tracked by Morningstar was 7%, over six times their published expense ratio of 1.15%. More broadly, funds in the Morningstar universe had a mean active expense ratio of 5.2%, while the largest funds averaged a percent or two less.”

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  1. [...] So who better to tell the story than Professor Ross Miller of SUNY Albany – a man whose paper on index hugging is in the Portable Alpha Hall of Fame.  Miller released this ringing indictment of Magellan last month.  [...]

  2. [...] *What’s important here isn’t the absolute value of these numbers, but their ratio (Sharpe ratio) which is about 1.0 – very good indeed.  Interested readers should note that the “active portion” would be closer to 50%, not 28% under the added constraint that the active portion have the same standard deviation as the market.  For much more on this type of analysis, see Ross Miller’s seminal paper on the topic.  [...]

  3. [...] Maybe I’m working too much.  But the more I research alpha, the less I know how to define it.  While Andrew Lo asks “Where does alpha come from?”, I’m now back at “What is alpha”? Â For example, what might look like alpha over one timeframe is actually “exotic beta” when you shift the window of analysis only a few months.  What looks like alpha vs. one benchmark may, of course, be beta when compared to a different benchmark.  There’s ”active weight“, “active component“, “active share“, “absolute returns”, “reliance on public information“, “manager value-added” – even ”accidental alpha“. [...]

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