What is the True Cost of Active Management? A Comparison of Hedge Funds and Mutual Funds

27 Pages Posted: 19 Jan 2012 Last revised: 17 Mar 2014

Jussi Keppo

National University of Singapore - NUS Business School

Antti Petajisto

New York University (NYU) - Department of Finance; Yale School of Management; BlackRock, Inc

Date Written: March 16, 2014

Abstract

On the surface, hedge funds seem to have much higher fees than actively managed mutual funds. However, the true cost of active management should be measured relative to the size of the active positions taken by a fund manager. A mutual fund combines active positions with a passive position in the benchmark index, which can make the active positions expensive. A hedge fund takes both long and short positions and uses leverage, which makes the active positions cheaper, but this can be offset by the expected incentive fees, especially for more volatile funds. We investigate the trade-offs from the perspective of a fund investor choosing between a mutual fund and a hedge fund, examining the impact of leverage, volatility, Active Share, nominal fees, and alpha for a realistic range of parameter estimates. Our calibration shows that a moderately skilled active manager is approximately equally attractive to investors as a mutual fund manager or as a hedge fund manager, showing that both investment vehicles can coexist as efficient alternatives to investors. Further, our model explains documented empirical findings on career development of successful fund managers and on hedge funds' risk taking. Finally, we show that our findings are quite robust with respect to a jump risk in the hedge fund returns.

Keywords: Management fee, performance fee, hedge fund, mutual fund

JEL Classification: C15, C61, G11, G29

Suggested Citation

Keppo, Jussi and Petajisto, Antti, What is the True Cost of Active Management? A Comparison of Hedge Funds and Mutual Funds (March 16, 2014). Available at SSRN: https://ssrn.com/abstract=1987512 or http://dx.doi.org/10.2139/ssrn.1987512

Jussi Keppo (Contact Author)

National University of Singapore - NUS Business School ( email )

1 Business Link
Singapore, 117592
Singapore

Antti Petajisto

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0378 (Phone)

HOME PAGE: http://www.petajisto.net/

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

HOME PAGE: http://www.petajisto.net/

BlackRock, Inc ( email )

400 Howard St
San Francisco, CA 94105
United States
415-670-7911 (Phone)

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