From the February 2007 issue of Investment Advisor • Subscribe!

The True Costs of Active Management

Think mutual funds are cheaper than hedge funds? Not a chance

Even the most rational investors must admit to temptation when the subject under discussion is actively-managed mutual funds. After all, it's nearly impossible to read an industry publication without seeing a prominent advertisement for the newest fund that's achieved a five-star rating, beaten the market or a specific index over a selected time frame, or managed to avoid the latest market meltdown. With so much ink spilled on many of these offerings, one might think nearly every active mutual fund has a long list of enviable attributes. But when held up to objective scrutiny, many open-ended funds that attempt to "beat the market" have a lot less going for them than one would imagine.

For starters, consider that most active funds are really closet indexers--in other words, they mimic their benchmarks to such a dramatic extent that there is precious little left in the kitty for market-beating activities. Rather than offering outsized gains, such trading, unfortunately, leads to losses, which causes many of these offerings to lag market indexes by big margins.

Same Old Story, but With a Brand New Headline

This message, of course, is far from new. Ever since Bill Sharpe first described a method of parsing the return of a fund into an active and passive component, so-called "style analysis" has fundamentally changed the way active funds are assessed. A recent study by Ross Miller of the State University of New York at Albany, Measuring the True Costs of Active Management in Mutual Funds, sheds considerable light on the subject.

Using the Fidelity Magellan Fund as an example, Miller shows that over 91% of its return comes from index-hugging; as a result, only about 9% of its assets are actually assigned to stock selection, which is the supposed raison d'etre of the fund's management team.

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Miller then calculates an active expense ratio by calculating how much more funds charge over the levy for an index fund, and assigns this amount to the percentage of the fund that is utilized for active trading. In the case of Magellan, its 0.70% management fee is reduced by 18 basis points (the cost of Fidelity's index product), which leaves us with 0.52%. When this balance is applied to the 9% of the fund that is actively managed, Magellan is left with an active expense ratio of 5.87%.

How much do investors benefit from this small amount of active management? According to Miller, the fund generated negative alpha of over 2.6% per year from 2002-2004. Investors paid dearly, in both expenses and trading losses, for that little sliver of Magellan.

These results were unfortunately much more the rule than they were the exception. Active expense ratios averaged around 5.2%, and market-beating results from trading around the index were few and far between.

A Better Mousetrap?

For investors keen on capturing market alpha, there has to be a better path. A possible solution can be found in Roger Ibbotson's newest study, The ABCs of Hedge Funds. His work examined the alpha generation, beta, and costs of hedge funds that make up the TASS database. Ibbotson found that, on average, hedge funds are significant generators of value-added return, and make for excellent diversification in a portfolio of stocks, bonds, and cash. As the table shows, every hedge fund category generated impressive alpha, even after taking fees into consideration.

Hedge funds certainly aren't cheap, but they do tend to generate profits above those found in traditional indexes. A better solution may be a combination of index funds with a smidgen of alternatives thrown in the mix. The strategy should certainly lower an account's internal expense ratio.

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