Are Hedge Funds a Bargain Compared to Actively Managed Mutual Funds?

With an average expense ratio of 1.3 percent, equity mutual funds can hardly be classified as cheap. But most investors would regard them as screaming bargains when compared to hedge funds, which typically carry annual fees of two percent plus 20 percent of any investment gains.

But according to a recent article in World Economics by Professor Ross Miller, you can make the case that actively managed mutual funds are actually much more expensive than hedge funds.

The returns of actively managed investments have two components. The first, known as beta, is simply the portion of the fund's return that is attributable to the return produced by the market that the fund invests in. Just as all sailboats are effected by the prevailing weather conditions, so all funds are impacted by the market's movements.

Because beta is available for 0.1 percent or less via an index fund, investors in actively managed funds presumably aren't paying higher fees because they want their managers to track the stock market. These investors are actually paying for the second component of an investment's return, known as alpha.

Alpha is the portion of the return that is attributable to the fund manager's investment decisions. In some cases those decisions are profitable, and produce a positive alpha, wherein the fund outperforms its benchmark. But in many cases, that alpha can be negative, resulting in benchmark-lagging returns.

While investors might believe that the lion's share of their fund's return is attributable to the buy/sell decisions of the fund's manager, the reality is precisely the opposite -- most of the return provided by actively managed funds is simply a product of the return provided by the overall market. This trait becomes more pronounced as funds grow larger and their portfolios end up looking more and more like the market itself.

To illustrate this, Miller highlighted American Funds' Growth Fund of America. With $154 billion in assets, Miller calculated that 87.5 percent of the fund is essentially passively managed, simply tracking the stock market, while only 12.5 percent is actively managed, dedicated to outperforming the market.

Because of this, Miller argues that active management fees should not be viewed as a percentage of a fund's total assets, but rather as a percentage of the fund's assets that are dedicated to what the fund's investors are really interested in -- outperforming the stock market.

When viewed that way, Miller argues that actively managed mutual funds are far more expensive than they appear. How much so? Miller calculates that the active management expense ratio for the average large-cap fund is not 1.2 percent as traditionally calculated, but 6.44 percent when weighed against the comparatively small portion of the funds' assets that is actually actively managed.

Viewed in that light, Miller argues that actively managed mutual funds are much more expensive than hedge funds, because unlike mutual funds, the majority of the assets (for better or worse) of most hedge funds is truly actively managed.

Curious to see if the staggering active management fees Miller calculated for large-cap funds would also be found in the rest of the mutual fund universe, I calculated active management expense ratios for each of the nine Morningstar style boxes, which you can see in the table below. I found that, on average, the active management expense ratio of these funds was 6.3 percent.

While I doubt that the mutual fund industry will soon adopt this method of calculating active management expenses, Miller's work certainly sheds a harsh light on the just how much mutual fund investors are paying for the hope of outperformance. Forewarned is forearmed.

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