The True Costs of Active Management

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.

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%.