Measuring the True Cost of Active Management by Mutual Funds

Fees 05 Jul 2006

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. George Tapper
    June 1, 2015 at 9:50 am

    Keeping the fees low is one of the big secret to grow up a successful hedge fund.

  2. Henry Motyka
    June 2, 2015 at 2:34 pm

    Thanks for some interesting thoughts and proposals. This was quite interesting.

    An important piece of this said: However, disappointed allocators are much more likely to fire an underperforming manager rather than press for changes in the current fee structure. It’s simply easier to allocate to a new manager who has been performing well, and hence has justified prior fees.

    That extra step of pressing for changes may one that investing managers neglect because it is too easy to look around. However, I always say that you, meaning anyone, is the most powerful person in the world if you just realize it. I think the same may go for investing managers.

    I think almost everyone in the investing world is now taking a closer and harder look at fees and there may be long term changes in the investing world.

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