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February 20, 2007
The True Cost of Active Management
Stock mutual funds come in one of two flavors: active or passive. Actively managed mutual funds are run by fund managers who buy and sell stocks trying to beat the returns of some benchmark index like the S&P 500. Passively managed funds, also known as index funds, are run by computers. Instead of trying to beat the average, they try to be the average, by buying enough of the stocks in a given index to mimic its performance almost exactly.
Individual investors overwhelmingly choose the more expensive actively managed funds in spite of over-whelming evidence they are inferior to index funds. Over the past five years, the S&P 500 has beaten 71.4% of large-cap funds, the S&P MidCap 400 has outperformed 79.7% of mid-cap funds, and the S&P SmallCap 600 has outpaced 77.5% of small-cap funds.
So what exactly are you paying for when you buy an actively managed mutual fund. Not much as it turns out.
A recent study by Ross Miller of the State University of New York at Albany titled "True Costs of Active Management in Mutual Funds," splits out the return by that which comes from the movement of the index and that which comes from active management.
Using Fidelity's Magellan fund as an example, Miller shows that over 91% of its return comes from "index-hugging". In other words, it comes from the fact that Magellan, like most actively managed funds, has a high percentage of its portfolio invested in stocks that make up its benchmark index. Only 9% of the return comes from stock selection, which is the reason, presumably, you pay a fee over and above what an index fund would charge.
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.
Miller's study finds these results are typical. The average active expense ratio was 5.2% and the active management portion of the portfolio generally dragged down its performance rather than enhancing it. This is consistent with the data on active versus passive funds published by Standard & Poor's which shows index funds have consistently beat actively managed funds over time.
So the long and the short of it is actively managed funds perform worse over time and cost more. So why do we continue to buy them. I believe it is because actively managed funds are sold. 401(k) plan administrators, brokers and financial advisors make big commissions on actively managed funds and little if any commission on an index fund.
In fact, in a glaring example of the conflict of interest that exists in the industry's compensation system, the worse a fund is, the more it is likely to pay the advisor who sells it. Think about it, if I am an advisor and I have two funds to sell - one has gotten exactly the same return as the market year after year for the last ten years, and the other has underperformed it by 4% year after year, all things being equal, which fund am I going to sell to my client?
But all things aren't equal are they? Because people are buying that fund. The reason they are buying that fund is Company B gives Mr. Financial Advisor a huge financial incentive to sell his fund. Otherwise, who in their right mind would ever buy it?
And what about all these 401(k), 403(b) and SIMPLE plans that are supposed to be the lynchpin of our retirement? Why are those plans filled with actively managed mutual funds? Why does the federal government's retirement plan use index funds but ours is filled with under-performing actively managed funds? Why do finance and economics professors overwhelming adhere to indexing strategies with their own money but Wall Street continues to sell us over-priced, under-performing actively-managed equity funds?
OK. Did you hear that sound? That was me getting off my soapbox.
But it really makes me mad. I believe in free markets - but to me, this seems to be a case where free markets don't work right. How does an inferior product that costs more continue to attract more dollars than the superior product? I just don't get it.
The only thing I can figure out is that it wouldn't unless investors get some other need met by investing in actively managed funds. It is obviously some emotional need. It certainly isn't logical.
What do you think? Do you own actively managed funds and if so why? Do you still believe they are a better investment than index funds? I would like to hear from you. Leave your thoughts and comments below.
UPDATE (3/6/07)- Ross Miller sent me the full version of his paper, "Measuring the True Cost of Active Management by Mutual Funds", published in this quarter's Journal of Investment Management. He was also kind enough to include an even newer paper focused specifically on the cost of active management in Fidelity's Magellan fund, called "Stansky's Monster: A Critical Examination of Fidelity Magellan's 'Frankenfund."
SOURCE: (direct quotes are indented and highlighted)
1. Ben Warwick. "The True Costs of Active Management." Investment Advisor February 2007; p 36.
http://investmentadvisor.com/article.php?article=7432
2. "Standard & Poor's Indices Versus Active Funds Scorecard, Fourth Quarter 2006." Standard & Poor's 17 January 2007.
http://www2.standardandpoors.com/spf/pdf/index/SPIVA_2006_Q4-sc.pdf
Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.
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Kim Snider is an author, speaker and host of Financial Success Coaching, Saturdays at noon, on KRLD Newsradio 1080, Dallas - Fort Worth. This blog is primarily devoted to empowering individual investors with information to help them be good stewards of their money. Above all, it is about achieving true financial success. Kim's book, How To Be the Family CFO: Four Simple Steps to Put Your Financial House in Order is in bookstores now. Order yours from Amazon or other fine booksellers today.
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