Review of Academic Article Related to Personal Investment

The Article:   Miller, Ross M., "Measuring the True Cost of Active Management by Mutual Funds" (June 2005). Available at SSRN: SSRN Website

The Author: Ross Miller has a PhD in economics from Harvard University.  He has taught finance and economics at the California Institute of Technology, Boston University, and the University of Houston and is president of Millers Risk Advisors, an investment management consulting firm.

The Closet Indexing of Actively Managed Funds.

Over time there have been many articles written that accuse actively managed funds of being 'closet index' funds.  That is, even though these funds charge a higher management fee and promotes themselves as being active fund manager, the reality is that the underlying investments are a lot like an index fund, at a much higher cost to the investor.

Amongst the reasons given for actively managed funds being closet index funds are the 'marketing imperative' and the problems of size. 

The 'marketing imperative' suggests that managed funds are reluctant to take big positions away from the index because if they do, and the positions don't work out, the fund will have underperformed the benchmark significantly.  This underperformance will be difficult to explain to existing investors and even more difficult to use to attract new investors.  So the safe alternative is to hold a portfolio that is roughly the same as the index, so that the managed fund will get roughly the same return. 

The problem of size means that large fund managers have so much money to deploy that they are forced to purchase investments in a large number of companies, just to get all their money invested.  For example, Colonial First State boasts on their website that they have $99 billion in funds under management.  Let us assume that 1/3 of this, $33 billion, is invested in Australian shares.  The sheer size of this sum of money requires that it is spread over many investments.  Particularly it cannot be focused too much in smaller companies, because they are not big enough for large portions of the $33 billion.  As such, the fund ends up with a large number of investments, tending to have bigger investments in the bigger companies, much like the index itself.

Ross Miller, in his paper 'Measuring the True Cost of Active Management by Mutual Funds', sets out to identify how much the returns from mutual funds, a US term for a managed funds, are a result of closet indexing and how much are a result of active management unrelated to the index.  He then proportions a reasonable fee for the index fund management based on the Vanguard S&P 500 Index Fund (0.18%) to find out the true cost of the actively managed portion of the fund.  That is, he assumes that the indexing investment management cost 0.18% for the portion of the fund managed this way, with the remaining management cost being attributed to the actively managed portion of the fund.

The results are very interesting.  For the 152 'large company' mutual funds that formed the sample, on average only 15.55% of the total funds were actively managed.  The average MER for the actively managed portion of the funds was 6.99%.  On average more than 96% of the variance in the returns of the fund was explained by movements in the index.  On average the 'value added' by the active management was negative 9%.  This is an investment loss of 2% on top of the fees of 6.99% apportioned to the actively managed component of the fund, clearly demonstrating that in this sample active management destroyed value.

On an overall basis the 152 mutual funds underperformed the index by an average of 1.5%.

It is worth making some comments on the study.  Firstly, the data sample was for an 18 month period from January 2002 to December 2004.  This is a short time frame from which to be drawing conclusions about performance.  Secondly, the results assume the cost of an index fund to be 0.18%, based on the Vanguard S&P 500 index fund available to retail investors in the US.  In Australia, the Vanguard Australian Share Fund has an MER of 0.7%.  Given this difference in the underlying cost of indexing it is reasonably to assume that the results would not have been as dramatic if this study were performed in the Australian Managed Fund environment.  Thirdly, the study does not consider the tax consequences of using an actively managed fund.  All performance considered in the study was before tax.  We know that actively managed funds tend to have higher portfolio turnover than index funds, and therefore higher levels of realised capital gains, which decreases their tax efficiency.

Overall the study provides a different perspective on the academic literature that widely questions the ability of active fund managers to outperform the index.  Its conclusion that the active management of funds does not add value for investors is consistent with much of the existing literature, including here in Australia.  It also provides a strong indication that the problem of 'closet indexing' is a significant issue in actively managed funds.  It is fair to suggest that this 'closet indexing' issue brings into question the value added by the managers of actively managed funds.

It also highlights one of the differences in using an index fund in Australia, with the cost of the Vanguard Australian Share Fund for a retail investor 0.7%, nearly four times the cost of the equivalent Vanguard investment for a US retail investor of 0.18%.  It seems reasonable to put these differences down to differences in the scale of markets and the difference in maturity of index funds in the two different markets.  According to the Vanguard websites in the US and Australia, Vanguard in the US has $950 billion in funds under management whereas Vanguard in Australia manages $36 billion.  Vanguard in the US was founded in 1975 whereas Vanguard in Australia was started in 1996.

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