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."
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.
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 (NYSEARCA: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 "remarkably high."
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.