February 20, 2013
The (Really) High Price Of Active Management
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 (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.
Posted by jp at February 20, 2013 7:28 AM
While I agree with the premise that cost is a drag against absolute return over long periods when "all else is equal", everyone here is assuming investors make the right decisions when faced with crisis and emotional stress. How many people sold during late '08 on fear, and didn't buy until halfway through '09? MANY. Behavior doesn't change with cost. And how many investors in actively-managed portfolios stayed in through the recovery because fear caused inertia? There is no data on this.
Also, I don't accept the premise that all low-cost ETFs accurately reflect the categories they portend to represent. One current example is HYG and JNK - due to tranche requirements, they don't accurately reflect the entire credit markets they are assumed to give access to.
Posted by: Mike at February 27, 2013 11:09 PM
Exactly correct JP, with a systematic rebalancing strategy there is no need to pray for a decade long bull market. Now don't get me worng, we'd love that too, but systematic rebalancing through high discipline, low cost, low turnover ETFs and open-end funds is the most consistent way to create quality returns over time. Not every day is sunny, but the overall long-term effect is much more attractive than the fallacy of active management.
It's just hard for the sales companies (translation: large Broker/Dealer firms) to compete on service and planning, so they need a sexy story to tell and change every 24 months to keep those commissions coming in.
Posted by: Bob Dignan at February 21, 2013 9:10 AM
JP is right about "narrow focus." If you had bought an ETF that tracks the S&P 500 in 1999, you didn't have much to show 10 years later. A broader allocation including small-caps, international (both developed & emerging markets), value and possibly a REIT element would NOT have created a "lost decade."
Also, active mangement is a loser's game any way you slice it. Year after year, most active managers cannot beat their respective index. Simple statistics should say that 50% should beat the index, but typically a majority don't and their fees play into that.
And, consider that many active managers are not comparing themselves to the proper index; they just want to use the S&P500. Well, if a manager beat the S&P500, but he/she did it using some small-cap stocks in their portfolio, then they beat the index using more risk. And they SHOULD beat the index in that case, because we should expect to be rewarded (larger gains) for more risk.
To say active management serves a purpose leads me to believe you are stil drinking some of that marketing kool-aid that Wall Street and CNBC serve up on a continous basis.
Posted by: Assnap Kined at February 21, 2013 8:37 AM
One point of disagreement is the notion that if you buy ETFs you must "hope for a bull market that lasts decades." True if you're going to buy one asset class, or one ETF. But the risk of relying on one trend in one asset class is somewhat mitigated (perhaps a lot) through an intelligent asset allocation/rebalancing strategy. Yes, the details matter, but this much is clear: no one should be betting the farm on one narrowly defined asset class and hoping for the best.
Posted by: JP at February 21, 2013 6:39 AM
Ah, no... the argument you're advancing seems to be that active management should really be based on perfromance. In other words,"make me money and I'll pay you one percent above the profit...". You and I know that's not the way it works. Investors just have to learn to pick the best managers or if they're lazy --- as most seem to be --- pray for luck. Or, just buy ETFs, hope for a bull market that lasts decades and when the time comes to retire cash out at the high end of the cycle. Active managment in my view serves a purpose and does passive. It is the combination of the two that helps your odds.
Posted by: Jenny Price at February 20, 2013 5:52 PM