Many do not fully understand how much they are paying for active management – it could be 5 times or more the quoted management/total expense ratios, depending on the manager’s strategy.
Some active funds do out perform the index, but most actively managed funds cannot and will not, however good the manager.
The additional return, as a multiple of a passive investible indexed return, that an actively managed mutual fund needs to return just to equal the passive return, increases the higher the total expense ratio, the lower the market return and the smaller the contrary position to the index.
Just for the sake of analysis, let us assume a 3% annual total expense ratio on an active fund, 0.25% on an indexed ETF, and a mutual fund asset allocation that is on average some 20% different from the market.
For an index return of 10% per annum, the actively managed component (the 20% that is different from the index) would need to earn 2.25 times the passive indexed return just to equal that return. Note the 80% that is the same as the index will return the index return less the total expenses of the fund.
The required multiple increases to 3.53 times for an index return of 5%.
Why does this happen?
The actively managed fund charges a high fee on both the contrary component of the fund and the part that is no different from the index.
You should, in fact, only be paying for the active decisions. With a total expense ratio of 3%, you should only be paying 0.25% for the 80% of the portfolio that is effectively an index position and because of this you are paying an effective total expense ratio of 14% on the active component. And of course we have not even talked about initial commissions and other costs.
So the higher costs of the fund and the smaller the difference between the manager’s strategy and the index, the higher the cost of active management, all else equal.
And, of course, it is unlikely that all a manager’s contrary positions will work out, so the required returns on the winners will rise to an even higher multiple.
Market efficiency and costs
What this all means, is that while markets may not be efficient in the general equilibrium sense of the word, they may just as well be for high cost mutual funds. In order to benefit form contrary positions in less than efficient markets, you need low fees and costs and reduced transactions. You should not be charging an active return on a non active component.
High expense ratios may also limit the amount of time a manager can realistically hold positions that are not performing as expected, and force him or her into areas of the market with positive price momentum. Higher turnover = higher transaction costs.
Marginal differential asset allocations of expensive actively managed funds are just not worth the cost and the risk. There is a role for active management, but it is at the margins and at much lower effective total expense ratios than conventional active management.
Additionally, if you have ever modelled the return profiles of contrary positions in trending markets, you will note that most contrary movements actually yield little performance benefit. What I mean here is that if you buy and sell relative value, the significance of the relative value is important, otherwise, for a number of reasons the return differential may add little or no value.
This means that you need to wait for significant valuation differences before taking asset allocation risks, which also means that active management may only pay off at key points in the valuation cycle.
This is an illustration of the dynamics of mutual fund costs and their impact on strategy and structure. While many may argue that mutual fund costs also include the trailer fees which compensate advisers, and that advisers who use ETFs also charge a separate fee, I would like to point out that many who accept trailer fees do little for the fee while those who charge for management of ETF based portfolios provide additional value through portfolio related planning and management functions. This does not absolve portfolio managers of the need to look at cost effective portfolio solutions and ultimately, the portfolio construction, planning and management process is itself capable of being moved to an automated process that will itself set a new benchmark for portfolio management fees. Just as ETFs have lowered broad asset allocation fees to the tenths of a percent, so could in time automation do the same for the portfolio.