A bit of maths will help clarify fund fee picture

(Published in the South China Morning Post on 12 Dec 2010)

How should you judge whether a fund’s fees are worth paying? This can be a very hard question to answer in an industry where the performance of products is so varied, either because markets are behaving strangely, as is their nature, or because the fund manager is performing poorly, as is the case more often than not.

Furthermore, while the results that funds produce vary hugely, management fees for actively managed equity mutual funds generally fall within a narrow band of 1.5 to 1.75 per cent per annum.

This is a little like a car industry in which all cars are priced the same but buyers are unsure whether they’ve bought a Ferrari or a Trabant, at least until it’s too late.

But then if fees are so standardised, why should buyers believe there is any way to differentiate between funds? To most it must seem impossible to judge a fund other than on the basis of whether it has performed well in the past, often a bad idea as the disclaimers remind us.

However, hope may be at hand for unit trust buyers seeking a more precise way to assess funds. Research by Ross Miller at the State University of New York titled Measuring the True Cost of Active Management by Mutual Funds identifies a clever way to measure whether a fund manager is pulling his weight and thus deserves a reward or is charging active fees for what is effectively a passive service or worse.

A bit of maths is involved but the concept is simple, namely to measure the portion of a fund that is being actively managed – termed the active portion. And once you do that, you can also calculate the effective returns and fees on that portion and thus better judge whether a fund offers value for money.

But what is active management?

To many it is about the amount of activity, or number of transactions within a fund – indeed this is how it was defined by Nobel economics science prize winner William Sharpe.

But to define it so would be to label the great buy-and-hold investors such as Warren Buffett, Peter Lynch and Philip Fisher as passive, an obviously absurd notion.

Rather, active management must be defined in terms of the extent to which a fund is different to those in the pack, not in terms of how frequently a fund manager buys and sells. It may be stating the obvious but for a fund to beat its benchmark, it must not look like the benchmark.

The fact that many do look like their benchmark is a sad indictment of the fund industry; it seems the business risk of getting it wrong is felt by many to outweigh the investment reward of getting it right.

Rather than getting bogged down with the calculation of active portion (those who would like to, can Google the aforementioned research paper), it is perhaps better to stay in the realm of the conceptual and grasp the notion that any fund in essence is a combination of an index fund, which is 100 per cent correlated with its benchmark, and a market-neutral hedge fund, which has zero correlation.

Precisely how you divide the two is a little complex but the concept should be clear. If not, try to understand that part of a fund’s return is due to the performance of the market – the “index” portion – and the rest due to what the fund manager is doing, the active portion. Miller’s formulae determine precisely which parts of the fund are doing which.

Now, let’s propose you should pay the same for the “index” portion as you would for an index fund, i.e. between 15 basis points for US equities and 70 basis points for Asian and emerging markets, and thus the rest of the fees are in lieu of the active portion, where the real effort is taking place, successfully or  otherwise. By isolating the index portion and the fees that relate to it – and thus arriving at the active portion and its fees – one can begin to get a good sense of whether one is getting good value for money.

Miller terms the fee that one pays for the active portion the active expense ratio (AER), and on this basis many of the US equity funds to which he applied his analysis looked very expensive, with AERs as high as 7 per cent of assets for some of them.

Of course, if a fund is capable of producing reliable outperformance, or alpha, then one should not begrudge paying a portion of this to the fund manager. Indeed two of the largest investment consultants in Australia recently suggested that fund managers should receive between a quarter and a third of alpha generated, but charge much lower fixed fees.

How can you use all this information?

Perhaps you could ask your financial adviser to download Miller’s paper – which contains his formulae – and then calculate which funds’ fees are worth paying. This may also prove a good test of whether he’s worth it.