Wealth Manager

AER’s goal is simple enough: Measuring the portion of expenses
directly tied to the active investment management. Think of AER
as a refined version of the gross expense ratio that’s reported in
every fund prospectus and otherwise dispensed by data vendors
such as Morningstar. Refining is vital because the gross expense
ratio is often misleading when it comes to measuring the true price
of active management, Miller says.

The reason is that most actively managed mutual funds harbor
some degree of influence from the market. Beta, in
other words, is a familiar, and sometimes dominant
companion in most actively managed mutual funds.
But gross expense ratio puts a price on the entire
portfolio, and so by that measure it’s unclear how
much a fund charges for alpha delivered, if any.

No longer. In a paper Miller penned last year, he
has come up with what he says is a practical solution
for calculating the cost of alpha. Titled “Active Expense Ratios
and Active Alphas” and available at MillerRisk.com, it outlines “a
method for allocating fund expenses between active and passive
management and constructs a simple formula for finding the cost
of active management.”

In a recent interview with Wealth Manager, Miller summarized the
central issue for fund pricing this way: “How much does the alpha
cost? It’s not obvious from looking only at the gross expense ratio.”

Crunching the data for Miller’s AER is enlightening, but not necessarily
encouraging. For example, at the end of 2004, the paper
notes, the mean AER for large-cap equity mutual funds tracked by
Morningstar was 7 percent—roughly six times higher than their
published expense ratio of 1.15 percent.

The good news is that by outing the real costs of active management,
the pressure is growing on funds to shave expenses. Exactly
how far any newfound thrift extends remains to be seen, although
Miller’s AER has received a fair amount of press over the past year.
The publicity, he suggests, has convinced some fund companies to
think twice about what they’re charging.

Because Miller’s paper is forthcoming in the Journal of Investment
Management, a new round of publicity for AER may be in the offing. To learn more about his formula, we recently caught up with Miller.

Q: What does your active expense ratio measure?

A: It allocates the costs of money management between the passive
and active components of a portfolio. You can think of an actively
managed mutual fund as having two parts: One portion is
comparable to an index fund; the other is an active part. When you
buy a mutual fund, you’re buying a package deal—a package of
beta and alpha. The active expense ratio measures the costs of the
assets that are being actively managed.

Q: How does it work?

A: Let’s say you had a money manager, and all he did was put your
money in a domestic stock market index fund, and for that privilege
he charged 100 basis points. You’re paying 100 basis points for something you can get for 10 basis points on a retail index fund like Fidelity Spartan. So, our manager is charging something like a 90-basis-point overcharge.

That’s an extreme case. A subtler example is an active fund that
closely tracks an index—not perfectly, but closely. Historically,
funds that closely track an index have low management fees relative
to other types of funds. Nonetheless, the question is, “How
do you figure out how much of your money is going for active
management and how much to passive management?” That’s a
critical issue because money managers often try to reduce tracking
error relative to an index. There’s nothing wrong with that,
but investors need an accounting of the costs because managers
aren’t always doing a lot of active management. A classic case is
the PIMCO Stocks Plus Fund, which is basically an S&P 500 index
fund with an overlay of Bill Gross’s bond picks. You’re not buying
a lot of active management in the fund overall and you’re paying a
fair bit for Bill Gross.

None of this, by the way, is an issue of judging the intentions of
the portfolio managers running funds. Rather, it’s an issue of accounting
for what’s actually happened. The managers could have
the best of intentions, but if you find that over a period of time
that you could do what the manager’s doing a lot less expensively,
money’s going to flow out of his fund.

Q: How is your active expense ratio calculated?

A: The formula has three key variables: The R-squared of the
fund you’re looking at against the relevant benchmark; the active
fund’s expense ratio; and the expense ratio of the investable
index fund that’s an appropriate alternative for capturing the
beta portion of the active fund.

Let’s say you have a large-cap domestic equity fund that charges
100 basis points for expenses and is said to be actively managed,
but in fact is a shadow index fund with an R-squared of 99 percent
against the S&P 500. If you ran the math for dividing beta and alpha
out, based on my paper, it turns out that roughly 91 percent of the
assets are passively managed and the remaining 9 percent, actively
managed. As a result, the active expense ratio is a steep 9 percent.

Q: How do you come up with 9 percent?

A: In my paper, there’s a formula for converting the R-squared,
which tells you how much of the variance in the active fund is explained
by the benchmark. I convert the R-squared into active and
passive shares of the portfolio. You can think of it as separating
alpha and beta. That’s the tricky intermediate step that converts
the 99 percent R-squared into 91 percent beta and 9 percent alpha
in the example I just gave you.

The next step is determining how to replicate what the fund’s
doing. Based on the numbers generated by my paper’s formula,
91 percent of the money would go into an appropriate index fund,
which you can get for 18 basis points in the Vanguard 500 Fund, for
instance. If you put all of your money in this index fund, the total
charge would be 18 basis points. But in this example of trying to
replicate the active fund, you’re putting 91 percent of the money
into the index fund. That works out to a charge of around 16 basis
points. In other words, 91 percent of 18 basis points comes to a
charge of 16 basis points.

What this means is that for the active fund that charges 100
basis points, you can reproduce the passive side for 16 basis points.
That leaves 84 basis points, which is the price of the 9 percent of
the fund that’s actively managed. That translates into an active expense ratio of more than 9 percent. So, in this example you’re paying quite a bit for the active management—much more than implied by the gross expense ratio of one percent.

You might also think of the calculation in absolute-dollar terms,
which makes the formula easier to understand. Using the same
fund example, a $10,000 investment in the active fund incurs total
fees of $100—that is, a 1 percent expense ratio. Of that $100, you’re
paying $16 for the roughly $9,100 that’s being passively managed.
And you’re paying $84 for the $900 that’s being actively managed.
It’s that $84 divided by the $900 that’s being actively managed that
gives you the roughly 9 percent active expense ratio.

Q: Is your active expense ratio the first of its kind?

A: Yes, and that’s why it’s been so popular. I’ve been at conferences
where I’ve had notable economists come up to me and say, “I’ve
thought about something like that.” But there are a lot of wrong
ways to do it. In the practitioner literature, for instance, people
have thought about using the R-squared number, but that approach
gives results that don’t make any sense, which is why I
modified R-squared in my paper.

Q: What’s the range of active expense ratios for mutual funds?

A: From 1 percent to over 20 percent. The best-case scenario is found
with the active funds from Vanguard, like the Wellington and Windsor
funds which tend to have active expense ratios in the 1 to 2 percent
range. In the next range up are the portfolios from American
Funds, for instance, which tend to have a 3 to 4 percent active expense
ratio. Above that are the low-fee shadow indexers, which are
in the 5 to 8 percent range. For funds with the highest active expense
ratios, the typical characteristics are portfolios with an R-squared of
98 or 99 percent and a gross expense ratio in excess of 2 percent.

Q: What’s your take on fees as related to active money management
these days?

A: I think people are getting wise to the fee issue, and so it’s putting
a lot of downward pressure on fees. There are still plenty of
active managers, and there probably always will be. But many investors
now see the portfolio process as one of capturing beta and
sector exposure through passive investments, and getting alpha
through targeted active investments.

Q: Does your active expense ratio work with hedge funds?

A: It’s more problematic if you’re trying to compare hedge funds
[because there’s not always an obvious benchmark or because leverage
employed can be relatively high.] On the other hand, for a
pure hedge fund—one that’s uncorrelated with the markets—its
overall fee is the active expense ratio. That’s because with a hedge
fund that’s pure active management, what you pay is only for active
management.

Q: What are the caveats to using your measure?

A: Within the current mutual fund world, the active expense ratio
does just fine. But like any other measurement—alpha, Sharpe
ratio, whatever—the simple form of my active expense ratio is
something that a clever manager can game because a clever manager
can game any performance measure.

Looking backward, however, the active expense ratio is a great
tool because no one knew it existed. But the world is changing, and
funds are being punished for being shadow indexers. If you look at
the funds that are working on becoming more active, they’re not
necessarily more active in absolute terms; they’re just more of a
hybrid. As a result, Morningstar is going to have to start abandoning
its single benchmark approach. Instead of asking what it costs
for a single benchmark, the question’s becoming: What does it cost
to reproduce the package of benchmarks? For a fund that engages
in active asset allocation, my method fails; in fact, pretty much all
of portfolio analysis method fails for that hybrid approach.

Q: Is that because there’s no obvious benchmark?

A: Right. I was sensitive to that from day one, because back when
I worked in asset management, I was head of research for a family
of products that involved sector rotation and country rotation.
There was no fixed benchmark. If you performed style analysis on
the portfolio, the results changed every month. But the number of
funds like that currently is still tiny.

Q: Is it fair to say that the value of your active expense ratio is dependent on having a reliable investable benchmark?

A: Right. You need to have something that’s a passive alternative
that consists of one or more investable indices.

Q: If mutual funds managers are targeting more than one benchmark,
the challenge of coming up with a good investable index
becomes tougher.

A: Yes, but the same is true for any performance analysis.