Webring
... this article shows that mutual funds are far 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 that engage 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 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 funds's published expensse 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. Viewed in this context, the fees of hedge funds that focus on active management do not appear so outrageous.
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Consider for purposes of illustration the Fidelity Magellan Fund at the end of 2004. Based on monthly data for the preceding three years, an investor could have replicated the risk and return characteristics of the fund (including its R-squared of 99%) by placing 90.87% of his or her assets in an index fund that tracks the S&P 500 and remaining 9.13% in an appropriately chosen market-neutral investment. In this new portfolio, 99% of the variance of this portfolio is explained by the index and we can leverage it in a way that Magellan's beta and variance are also replicated. If we then take 18 basis as the expense ratio for the passive component of Magellan (the same ratio as the version of Vanguard's S&P 500 index fund marketed to individual investors), Magellan might be seen as "overcharging' investors by 52 basis points on the passive component of its portfolio. If we were to assess those 52 basis points against the 9.13% of the portfolio that is actively managed, we would find that annual expenses account for 5.87% of those funds.
The 5.87% annual cost of the active management implicitly provided by Magellan's management, which we will call its active expense ratio, could be justified on economic grounds if the fund provided superior returns to its investors.
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When Magellan's alpha of -2.67% per year over that period is allocated solely to the active component of its portfolio, it has an active alpha of -27.45%. ...
Measuring the True Cost of Active Management by Mutual Funds
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