It's no secret that indexing is considerably less expensive than
active management. It's also well established that indexing's lower
price tag often provides a considerable performance advantage when
measured over time. As it turns out, the drag from higher active fees is
far larger than generally known. A recent article by consultant/strategist Charlie Ellis (author of the must-read book Winning the Loser's Game) in the Financial Analysts Journal is a real eye-opener on this score. As he explains, "investment management fees are (much) higher than you think."
[Related -8 Stocks to Beat Warren Buffett's Portfolio Return Easily]
The basic issue is that when you pay, say, a 1% expense ratio for a
mutual fund, you're paying that fee for both the market beta and alpha
earned through active management. That's a problem because the price of
beta is low—really low, for some asset classes. Yet active managers tend
to price this portion of returns at the active management rate. In
other words, most (all?) actively managed products are charging an
active fee for beta. Translation: you're paying a steep price for a
commodity that's available at a deep discount elsewhere.
[Related -How the Chinese Slowdown Will Impact Your Investments]
To take an extreme example, consider US large-cap stocks. Let's
imagine that the market returns 7% a year over some time period.
Meanwhile, an active manager beats the odds and delivers a
market-beating 8% a year. In that case, he added one percentage point of
alpha over the market's 7 percentage points of beta. The price tag for
this alpha? Let's say the manager charges 1% of assets, which is fairly
typical (give or take) for many actively managed funds. By comparison,
you can buy US equity beta for 0.05%, based on the expense ratio of Vanguard S&P 500 ETF (VOO), to use one of many examples of low-cost products in this space.
It's already clear in this example that you're paying substantially
more for active management. That's a big headwind over time—all the more
so if the manager delivers minimal alpha or trails the market. Since
most active managers add little, if any, value over a relevant
benchmark, this is no trivial issue.
Unfortunately, it gets worse. Much worse. As Ellis notes:
When stated as a percentage of assets, average
[active management] fees do look low—a little over 1% of assets for
individuals and a little less than one-half of 1% for institutional
investors. But the investors already own those assets, so investment
management fees should really be based on what investors are getting in
the returns that managers produce.
Here's the critical point:
Calculated correctly, as a percentage of returns, fees no
longer look low. Do the math. If returns average, say, 8% a year, then
those same fees are not 1% or one-half of 1%. They are much
higher—typically over 12% for individuals and 6% for institutions.
Alas, we're not done yet:
But even this recalculation substantially understates the real
cost of active "beat the market" investment management... investors
should consider fees charged by active managers not as a percentage of
total returns buts as incremental fees versus risk-adjusted incremental
returns above the market index.
Of course, that's not how money management works. Instead, active
managers charge a fee on all the assets under management, including any
gains in totality. But you should only pay an active fee for the active
results—the extra return, if any, that you receive over and above the
index. If you own an actively managed fund, you're probably paying for
both beta and alpha, which means that you're paying an unusually high
fee for the dominant slice of the returns--the beta slice.
That's a rather big problem. As Ellis reminds, when management fees
are accurately stated, the price tag for active management is
Incremental fees are somewhere between 50% of incremental
returns and, because a majority of active managers fall short of their
chosen benchmarks, infinity.
The good news: avoiding the active management pinch is easy. A
different set of letters in a fund's ticker can make a big difference.