Cheap Beta: The Foundation of Alpha Centric Investing

by: Christopher Holt

There is little argument that many mutual funds contain a whack of beta and very little alpha. So a mutual-fund-replicating portfolio comprising explicitly of both alpha and beta would naturally require a lot more beta than it would alpha. That’s why the price of beta is so critical to making a synthetic mutual fund portfolio work.

But unfortunately, not all beta is cheap. While institutions can often get beta “thrown-in for free” from their active manager (even at a “negative management fee” if they lend out this stock), retail investors can blow the bank if they don’t watch out. This article in this week’s Barron’s shows that index funds (a popular source of beta) range in cost from 0.07% to 1.45% (20 times higher!).

What could possibly justify such a wide price range? According to Barron’s, part of the reason is the 12b-1 fee (”marketing fee”) charged by the higher priced funds. For non-US readers, “12b-1″ is essentially a nifty synonym for “adviser’s trailer”. A Wake Forest University study says approximately two thirds of 12b-1 fees get funneled back to the advisers who recommended the fund. But According to Barron’s, the Chief Economist of the Investment Company Institute says the real proportion going back to advisers is closer to 98%(!)

The Wake Forest Study’s authors tell Barron’s:

“The important question is not why certain funds are more expensive, but why investors who receive investment advice from brokers invest in more expensive funds.”

Tough line of questioning to be sure. But they actually sugar-coat their conclusions for Barron’s. Take a look at the abstract from the actual study:

“The findings suggest that brokers are not acting in the best interests of their clients. The use of a broker to advise mutual fund investment decisions causes investors to pay twice - once to the broker for his bad advice and then again in the form higher ongoing annual fund operating expenses.”

“If a consumer spends $4 for a loaf of bread when an identical loaf on the same shelf cost $2, it is no defense for a ‘bread broker’ who recommends the $4 loaf to argue that it cost more because the baker has higher production costs than the baker of the $2 loaf. The extra $2 paid by the consumer is a broker penalty, and the fact that the consumer paid for that advice simply adds insult to injury. We found that investors who use brokers to buy mutual funds, rather than benefiting from the broker’s professional guidance, pay a broker penalty in the form of higher fund fees, on top of the distribution fees paid to the broker.”

Ouch! Bear in mind, however, that the study was generously supported by shareholder-advocacy group Fund Democracy and Zero Alpha Group, a network of advisers who shun all forms of active management.

Still, the moral of the story seems to be that successful alpha-centric investing must be built on a foundation of cheap beta. Otherwise, it’s probably best to stick with your high-priced mutual fund.