Objective research to aid investing decisions

Value Investing Strategy (Strategy Overview)

Allocations for June 2020 (Final)
Cash TLT LQD SPY

Momentum Investing Strategy (Strategy Overview)

Allocations for June 2020 (Final)
1st ETF 2nd ETF 3rd ETF

Outing the (Negative) Alpha

| | Posted in: Mutual/Hedge Funds

In his June 2005 paper entitled “Measuring the True Cost of Active Management by Mutual Funds”, Ross Miller decomposes mutual fund performance into two components: (1) a passive, index-tracking or “closet index” component; and, (2) an actively managed component that generates abnormal returns. What if, he asks, one assigns an index-like portion of annual mutual fund fees (such as the 0.18% expense ratio for Vanguard’s S&P 500 Index Fund) to the passive component and the balance of the fees to the actively managed component? How expensive would active management be, say, in comparison to hedge fund fees? In tackling these questions using the Morningstar database, he finds that:

  • An appropriate benchmark index (for example, the S&P 500 index for a large-cap fund) explains over 90% of the variation in returns for a typical mutual fund.
  • As of the end of 2004, the mean active expense ratio for a sample of 152 large-cap equity mutual funds is 6.99% (ranging from 2.61% to 9.36%), over six times the mean published overall expense ratio of 1.15%. These funds have an overall mean alpha of -1.5% and a mean active alpha of -9.0%.
  • As of the end of 2004, the mean active expense ratio for all 4,752 index-comparable mutual funds tracked by Morningstar is 5.20% versus a mean published overall expense ratio of 1.26%. These funds have an overall mean alpha of -0.6% and a mean active alpha of -3.2%.
  • Active expense ratios tend to be relatively low for the very largest funds.

In summary, the active management component of broadly diversified (closet index) mutual funds is generally expensive and ineffective. In comparison, hedge funds with 100% active management are not that pricey.

Login
Daily Email Updates
Filter Research
  • Research Categories (select one or more)