Articles
 "Measuring the True Cost of Active Management by Mutual Funds," by Ross M. Miller, Journal of Investment Management 5, No.1 (First Quarter) 2007, pp. 29-49.
In this article, Ross Miller demonstrates that actively managed mutual funds are more expensive than commonly believed. The reason is that funds bundle passive and active management in a way that understates the true cost of active management. Funds that engage in "closet" indexing charge investors for active management but actually provide little more than indexed portfolios. In fact, over 90 percent of the variance of the average fund's returns is explained by its benchmark index. A method is derived for allocating mutual fund expenses between active and passive management, and a formula for calculating the cost of active management (apart from the passive exposure) is constructed. This formula requires only published data. In 2004, Ross finds, the mean expense ratio for the active portion of Morningstar's large-cap equity funds was 7 percent, which was six times the published expense ratio. In 2004, 99 percent of the variance of the Fidelity Magellan Fund's portfolio was explained by its benchmark index. Relative to the Vanguard S&P 500 Index Fund, Magellan "overcharged" investors by 52 basis points on the passive component of its portfolio. Magellan's expense ratio on its actively managed portfolio component was 5.87 percent versus 0.70 percent on its overall portfolio. What's worse, investors got poor performance for this active exposure: The portfolio's actively managed alpha performance was -27.45 percent versus -2.67 percent for the total fund. The last twenty years have seen the rise of index mutual funds and hedge funds, and investors have become increasingly skeptical of investment management. Once investors were able to "own" stock indexes, index funds became viable investments. Further, Sharpe's introduction of style analysis and Morningstar's popularization of it changed the way the performance of traditional money managers was assessed: They were then given credit only for performance they were determined to have earned by active management. The active management expense ratio provides the true cost of active management in a single number. The measure requires only a virtual decomposition of fund assets into passive and active components, which requires calculating the fund's explained variance relative to its benchmark index. Then the fund's active management expense ratio and its active performance alpha can be computed from readily available data. This approach derives from the Black-Scholes-Merton model and, more recently, from the use of "portable" alpha strategies. In principle, these developments allow the holder of an actively managed mutual fund to swap it for a more suitable active portfolio. By isolating the active component of a fund, its costs and performance can be directly compared to other actively managed investments in bundled or unbundled form. In this light, the so-called outrageous fees of market-neutral or predominantly active hedge funds may not look so outrageous when compared to traditional, actively managed mutual funds. The study provides an analysis of large-cap mutual funds. A summary of the overall and active management expense ratios, respectively, from 2004 Morningstar data follows:
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