We recently told you about the decision to steer clear of regulating investment management fees by the UK’s Financial Services Authority (FSA). After entertaining the notion of being a de facto “price regulator”, the FSA ran for the hills when it felt that it was taking on a sort of consumer protection role. Wrote the FSA in a 2007 ruling (p. 43):
“We do not act as a price regulator, and we do not consider it appropriate for us to take such a role.”
You may also recall this November 2009 post about the US Supreme Court’s decision to steer equally clear of the question of “fairness” in mutual fund pricing. A 2008 judicial ruling upheld the so-called “Gartenberg Standard” to determine whether an investment management fee was fair. The Gartenberg Standard (created in 1982) essentially rejects the argument that a fee is unfair just because competing fees are lower. The 2008 decision affirmed the Gartenberg Standard by ruling in favor of a fund company (Harris Associates) that charged retail investors way more than it did institutional ones. The chief judge in that case echoed the FSA’s 2007 ruling above when he said:
“…The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth.”
In other words, caveat emptor.
This case and others are contained in a new paper by Ross Miller of the State University of New York (Albany). Miller has been a long-time critic of mutual fund fees. Regular readers may recall his earlier seminal work on calculating the “active cost” of mutual funds (read paper here – highly recommended). Miller revisits the idea of active cost in the context of the ongoing regulatory debate concerning mutual fund fees. He also makes a direct comparison between mutual fund fees and hedge fund fees.
By upholding Harris Associates’ court victory, Miller argues that the US Supreme Court “has done retail investors no favors.” He adds that in any case,
“…fees that might appear reasonable by any standard can still have a devastating effect on investors that will not be realized until they actually need the money.”
This is especially true in defined contribution plans and retirement programs such as the 401(k) in the United States. Since investors in these plans are likely to remain invested for 30 or more years, the cumulative effect of management fees is often larger than the (deferred) income tax paid when funds are eventually withdrawn.
With the growing trend toward switching defined benefit (DB) plans with defined contribution (DC) plans, more employees are now, in Miller’s words, “…held captive by the mutual funds chosen by their employers.”
He points a finger at some DC plans that effectively have a “revenue share” with the mutual funds they provide in their plans. In these cases, high-fee mutual funds can basically cover the sponsor’s costs to administer the DC plan out of its own revenues, leaving “employees with the impression that they are getting something (the administration of the plan) for nothing”, when they are actually paying for these services in the from of higher management fees.
Hedge funds are “less expensive”
Attacks on mutual fund fees are nothing new. But where does that leave hedge funds with their “2 and 20″ fees. After all, even a hedge fund fee of 2% dwarfs those of many US mutual funds. Those unfamiliar with Miller’s previous work may be surprised by his answer:
“…high-priced active management that hedge fund managers provide tends to be considerably less expensive than that provided by mutual funds.” (our emphasis)
In a reprise of his 2005 paper, he suggests the following rule of thumb when comparing funds (of either the hedge or mutual varieties):
- Determine the ratio of passive risk to active risk. For example, a 98% r-squared to the S&P 500 is a 49-to-1 passive to active risk ratio.
- Take the square root of both sides of this ratio (i.e. 7-to-1). This is the amount of purely passive and purely active investment dollars needed to replicate the fund in question. This particular fund is therefore seven parts (87.5%) passive and one part (12.5%) active.
- Assume a cost for the purely passive component is, say, 20 bps per annum. Multiply the active proportion by 20 bps to determine the share of costs resulting directly from the passive component (87.5% x 0.20% = 0.175%).
- Subtract that passive cost from the overall cost of the fund (say, 0.75%). This means that the active component of the fund is responsible for (0.075-0.175%=0.575%) of the overall 0.75% management fee.
- Finally gross this cost up by factor of 8 since the active portion of the fund only represents one-eighth of the value of the fund (remember it’s 7 parts passive and 1 part active). This is .
A market neutral ” 2 and 20″ hedge fund with a return of 12% would still charge less than this mutual fund for active management (4.4% vs. 4.6% for the mutual fund above).
Granted, many hedge funds are not market neutral. In fact, a hedge fund with a 4.4% total fee and a relatively benign r-squared of 50% would be charging a whopping 8.6% for its purely active proportion. But that only underscores the importance of not making a summary judgment about hedge fund fees without first thinking through this analysis.
Hedge funds: lower volatility
Making matter worse for our mutual fund above, the volatility of its active component is significantly higher than that of a typical market neutral hedge fund. A loss of 1.46%, for example, would translate into a loss of (1.46% x 8 = 10.28%) if one were to make an “apples-to-apples” comparison with a market neutral hedge fund. But as Miller points out, “A market-neutral hedge fund with such a poor showing over a three-year period would likely either be forced or choose to close up shop and return its investor’s money.”
Is a 4.6% cost for active management in this example typical? The short is “yes” according to Miller. He analyzes over 700 large cap US mutual funds and finds that the mean is actually 6.44% per annum (see chart below from paper – click to enlarge).
He concludes by lamenting the slow pace of legislative reform that would help investors understand calculus like this. For example, he argues that pension plan administrators should be required to provide the dollar amount of fees paid by plan participants.
Remember the “Unemployment Compensation Extension Act” signed into law a couple of months ago to keep unemployed Americans afloat? The initial version of the bill contained a section on DC plan fee reporting that mandated plan administrators to provide employees with:
“…A statement of the total fees and expenses which were directly deducted from the participant’s or beneficiary’s account during the quarter and an itemization of such fees and expenses.”
But the mutual fund industry “slammed” this section of the bill, arguing that it could conflict with existing government efforts in this area. Alas, this section was missing in action by the time the bill hit the President’s desk. Looks like hedge funds aren’t the only ones being attacked for their fees.