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Measuring the True Cost of Active Management by Mutual Funds

Author

Listed:
  • Ross M. Miller

    (State University of New York at Albany)

Abstract

Recent years have seen a dramatic shift from mutual funds into hedge funds even though hedge funds charge management fees that have been decried as outrageous. While expectations of superior returns may be responsible for this shift, this article shows that mutual funds are more expensive than commonly believed. Mutual funds appear to provide investment services for relatively low fees because they bundle passive and active funds management together in a way that understates the true cost of active management. In particular, funds engaging in “closet” or “shadow” indexing charge their investors for active management while providing them with little more than an indexed investment. Even the average mutual fund, which ostensibly provides only active management, will have over 90% of the variance in its returns explained by its benchmark index. This article derives a method for allocating fund expenses between active and passive management and constructs a simple formula for finding the cost of active management. Computing this “active expense ratio” requires only a fund’s published expense ratio, its R-squared relative to a benchmark index, and the expense ratio for a competitive fund that tracks that index. At the end of 2004, the mean active expense ratio for the large-cap equity mutual funds tracked by Morningstar was 7%, over six times their published expense ratio of 1.15%. More broadly, funds in the Morningstar universe had a mean active expense ratio of 5.2%, while the largest funds averaged a percent or two less.

Suggested Citation

  • Ross M. Miller, 2005. "Measuring the True Cost of Active Management by Mutual Funds," Finance 0506010, University Library of Munich, Germany, revised 02 Aug 2005.
  • Handle: RePEc:wpa:wuwpfi:0506010
    Note: Type of Document - pdf; pages: 23
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    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0506/0506010.pdf
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    References listed on IDEAS

    as
    1. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    2. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    3. Dybvig, Philip H & Ross, Stephen A, 1985. " Differential Information and Performance Measurement Using a Security Market Line," Journal of Finance, American Finance Association, vol. 40(2), pages 383-399, June.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. Wilson Sy, 2009. "Towards a national default option for low-cost superannuation," Accounting Research Journal, Emerald Group Publishing, vol. 22(1), pages 46-67, July.
    2. David Eagle, 2005. "The Indexing Paradox -- Be Thankful for Irrational Investors," Finance 0512034, University Library of Munich, Germany.

    More about this item

    Keywords

    mutual fund expenses; cost allocation; active expense ratio; active alpha; portable alpha;

    JEL classification:

    • G - Financial Economics

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