Windham Capital Management, LLC
December 1, 2009
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Investors are well aware of the incremental transaction costs managers incur as they seek to replace securities perceived to be overvalued with those perceived to be undervalued. Moreover, it is no secret that active funds charge significantly higher fees than passive funds designed to track market indexes. It is perhaps not as widely understood, however, that there is a hidden cost associated with most active funds. The typical active fund is more than 90% correlated with the market. Yet their relatively high active management fee is applied not just to the fund’s active component but to its market component as well. Rather than pay active fees on total assets, including those that provide market exposure, an investor could achieve essentially the same result before fees by allocating most of the portfolio to an index fund with the residual allocated to a pure alpha fund that nets out market exposure.1 The following example illustrates this hidden cost of active management.
Table 1 shows the monthly returns and values of a hypothetical actively managed fund and an index fund, assuming an initial investment of $10 million. The index fund serves as the benchmark for the active fund.
In this example, the active fund generates a 2.00% alpha with active risk equal to 3.23% for a respectable information ratio of 0.62. If this performance is consistent with past results, it would not be unreasonable for the fund to charge a fee of 100 basis points or more. The active fund used in this example is anonymous, but it ranked in the top 2nd percentile of US equity funds for the 10-year period ending in 2008.
We might be tempted to hire this talented manager, but let us first consider an alternative course of action. Suppose we instruct the manager to deliver a fund that comprises only the active bets of the portfolio. The manager would achieve this result by first putting the capital to work in a short-term investment fund. Let’s suppose this fund earns 4.00% annually. The manager then sells short the index fund and uses the proceeds of these short sales to purchase the stocks that are expected to outperform, and levers these exposures 12 to 1. By employing this approach, the manager delivers a pure alpha stream rather than the composite of market returns and alpha that make up the active fund. Table 2 shows the returns and values of this pure alpha fund, assuming an initial investment of $10 million.
1 A fund manager could achieve a pure alpha exposure by purchasing securities that would otherwise be over weighted in a long only portfolio and selling short securities that would otherwise be underweighted in a long only portfolio. Alternatively, a fund manager cold sell futures contracts to eliminate a fund’s market exposure.
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