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Measuring the True Cost of Active Management by Mutual Funds

24 Pages Posted: 23 Jun 2005  

Ross M. Miller

Miller Risk Advisors; SUNY at Albany - School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: June 2005

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.

Keywords: Mutual fund expenses, active asset managment, mutual funds, hedge funds, active expense ratio

JEL Classification: G12, G23

Suggested Citation

Miller, Ross M., Measuring the True Cost of Active Management by Mutual Funds (June 2005). Available at SSRN: https://ssrn.com/abstract=746926 or http://dx.doi.org/10.2139/ssrn.746926

Ross Miller (Contact Author)

Miller Risk Advisors ( email )

2255 Algonquin Road
Niskayuna, NY 12309-4711
United States
518-346-0781 (Phone)

HOME PAGE: http://www.millerrisk.com

SUNY at Albany - School of Business

1400 Washington Ave.
Albany, NY 12222
United States

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