I was asked yesterday to work out how much active management costs compared to passive management through indexed Exchange Traded Funds. I revisited some long and complex literature from independents and academics to try to find an honest answer. It was where we began in the summer of 2007 when setting up Evercore Pan-Asset, thinking through what would be the best and most cost effective approach for clients.
You can look at the Total Expense Ratios (TERs) which the FSA and the US regulators ask all to publish. These show that the TERs of active funds are usually 0.5% to 1.5% higher than the equivalents from ETFs. The Total Expense Ratio comprises the investment management fee, the administrative costs, and the legal and audit fees. In the case of US mutual funds the figures are set out in the latest Frontier Capital Report entitled "When is a Total Expense Ratio not a Total Expense Ratio?"
Frontier Capital go on to argue that you also need to add in transaction costs within the funds, and the entry and exit costs for investors using the funds. They set out the resulting increases in total costs when transactions are taken into account. In the US a large-capitalisation equity fund incurs an average of 0.9% of costs on top of the average 1.3% TER, a small capitalisation fund 2.5% on top of a 1.6% TER, and an emerging market fund 7% on top of a 2% TER. They suggest that UK funds are dearer on average than US ones. There are also dealing costs in ETFs that need to be compared to the entry and exit costs for active funds, which should normally be lower.
Ross Miller's paper entitled "Measuring the true cost of Active Management" seeks to tease out the underlying cost, given that a lot of active funds in practise are largely closet indexers, taking only small bets away from the Index they are trying to beat. He splits out the active part that is trying to make a difference, and works out expense rates on the active portion. This gives very high figures for the average fund, yielding an overall active expense ratio of 5.2% on a published TER of 1.26% for the 4752 funds he studied. This in my view exaggerates the true costs but makes an interesting point.
The answer is that properly chosen indexed funds should be considerably cheaper than actively managed funds. Many active funds not only have higher TERs, but also incur more substantial transactions costs within the fund which you need to consider. Each case needs to be looked at in detail, as there is a wide range of costs in all types of funds including indexed ones.
We look not just at the TER of an ETF, but more importantly at the tracking error after all costs. That, after all, is what the client experiences. Some ETFs have got this down to a very low figure of a handful of basis points where 1% is 100 basis points. You need to ask the same question for active funds. You need to look at gains or losses against the index after all costs. The average fund shows losses, as the costs are too high to offset. As our graphs on this site show, the typical experience of active management in given asset classes can be a loss of 2% per annum (200 basis points) against the index. There are a few active winners, but they don't tell you in advance which they are going to be!
We would be delighted to look at your portfolio and to see how much partial and complete indexation we could cut your expenses by, even after allowing for a modest fee for ourselves!