How active managers have outperformed

Imagine that your doctor had two scales. On one you were weighed barefoot; on the other, because the law required it, you had to wear shoes. On which scale would you prefer to be measured if weight loss was your goal?

In investing, something similar is going on. Active managers managing institutional portfolios use a legal structure whose costs may be analogous to a pair of light socks, while the same managers managing virtually identical retail portfolios have had no choice but to use a legal structure that imposes higher costs. That structure is the mutual fund, and if you remove the costs of running a portfolio inside the mutual fund structure, many active managers actually outperform their benchmarks.

Those costs are not insubstantial. Research conducted by Navigate Fund Solutions found that certain embedded mutual fund administrative and trading expenses amounted to an average cost of 106 basis points of fund net assets on an equal-weighted basis and 79 bps on an asset-weighted basis over the 2007 to 2013 study period.

Absent these costs, the research found that the performance of actively managed funds compared quite favorably to ETFs over the study period when measured against three major indexes. In fact, active managers on average outperformed the S&P 500 Index by 10 bps and the Russell 2000 Index by 43 bps on an equal-weighted basis.

So what, exactly, are the fund costs that dampen performance? The study identified four:

Distribution and service fees. A mutual fund is permitted to charge distribution and service, or 12b-1, fees of up to 100 basis points of net assets annually. These fees are paid to the fund’s distributor, and generally passed through to broker-dealers and other financial intermediaries representing shareholders. Mutual funds are frequently offered with multiple classes of shares, which vary based on the assessed level of 12b-1 fees and the sales charges that apply, if any. Like sales loads, 12b-1 fees remitted to financial advisers are compensation for fund sales activity and fund-related client services.

Transfer agency fees. These fees represent the costs of administering a fund’s shareholder accounts and processing share transactions. A fund’s transfer agent is responsible for maintaining shareholder accounts, processing purchases, redemptions and exchanges of shares, and disbursing fund distributions. TA fees vary among funds based principally on average shareholder account size (larger average accounts usually translate into lower TA fees per dollar of fund assets) and the scope of shareholder services provided.

Flow-related trading costs. Mutual funds almost always issue and redeem their shares in cash. Funds experiencing net inflows generally buy securities to put invested cash to work, and funds in net outflows normally sell portfolio securities to raise cash to meet redemptions. Buying and selling portfolio securities in response to shareholder flows causes a fund to incur additional trading costs beyond what is required to implement the fund’s investment program.

Cash drag. Cash drag is the cost to a mutual fund’s performance that comes from not being fully invested. Mutual funds may hold cash in connection with their net inflows (new dollars not yet deployed), net outflows (a reserve against future withdrawals) and/or for tactical investment purposes. During periods when returns on a fund’s securities investments exceed cash returns, cash drag hurts fund performance; conversely, when returns on a fund’s investments are less than cash returns, holding cash helps fund performance and is then a negative cash drag.

Exchange-traded funds provide a structure that eliminates most or all of the costs that are embedded in the conventional mutual fund structure. But ETFs, of course, were created as passive investment vehicles to track a benchmark. Actively managed ETFs have been created as a way to marry the advantages of active management and the ETF structure, but these hybrids have proven to be problematic because the daily position reporting requirements of an ETF impede portfolio managers’ ability to add alpha through skillful trading.

One new SEC-approved structure, NextShares, eliminates the either/or choice of indexing versus active management. It combines many of the efficiencies of the ETF structure with active management, so that fund managers can continue to add alpha while investors reap the benefits of those potential returns as well as lower administrative costs. In a sense, NextShares brings institutional efficiency to individual investors.

For investors seeking the advantages of active management, this new structure may well prove rewarding.

Register for the August 25 live video webcast, How cutting the expense drag on active management will benefit clients.

For more information, download the white paper “Avoidable Structural Costs of Actively Managed Mutual Funds” now.