Just when you thought things couldn’t get any worse for actively managed mutual funds and their high MERs (Management Expense Ratios)…

Closet Indexing

Large actively-managed mutual funds can sometimes fall into the category of being a “closet indexer”. This refers to the fact that the holdings in the fund can closely resemble the stocks that make up it’s benchmark index. This begs the question: Why pay 2.5% for something very similar to an index fund which can be had for about a tenth of the cost?

Active Share

Oh it gets worse when you look at it a different way! Active Share is a concept which examines how much different a fund is from it’s benchmark index. Let’s pretend that we have a market index that is only made up of two companies, ABC and XYZ and both have a market cap of $1 billion. Let’s further pretend we have an actively managed mutual fund with $1 million in assets. It holds $450,000 worth of ABC and $550,000 worth of XYZ.

In the index, both ABC and XYZ represent 50% of the index. In the mutual fund ABC is 45% and XYZ is 55% of the fund. The fund has a 5% Active Short Position in ABC (50% – 45%), and a 5% Active Long Position in XYZ (55% – 50%). The overall Active Share of the fund is calculated by adding up the Active Long and Short positions and dividing by 2. For this fund we get (5% + 5%) / 2 = 5%.

So What Are You Paying For?

This is an extreme example, but you should calculate the MER based on the Active Share, not the portion of the fund that is indexed. You can replicate 95% of this fund by buying an index fund and only paying 0.25% on it. The remainder 5% of the fund is what you should apply the Management Expenses to to calculate the REAL Management Expense Ratio. So if the fund’s MER is 2.5% in the prospectus it equates to $25,000 on $1 million. If you instead apply this $25,000 to the active share of 5% or $50,000 the MER skyrockets to 50%!

Say That Again?

You could buy an index fund for 0.25%/year with $950,000 of your $1 million and then you would have $475,000 in each of ABC and XYZ since this index fund mirrors the index. To achieve $450,000 exposure to ABC, you could short $25,000 worth of ABC stock. To achieve $550,000 of XYZ you could go long $75,000 worth of XYZ stock. Now you have the same composition of the original actively managed fund: $450,000 exposure to ABC and $550,000 exposure to XYZ.

The $950,000 in the index fund cost you $2,375/year ($950,000 * 0.25%). Is the decision to additionally go short $25,000 worth of ABC stock and to go long an additional $75,000 worth of XYZ stock really worth an extra $22,625? ($25,000 – $2,375)

Probably not when you look at it that way.

To Be Fair…

You’ll note that I alluded to the Active Share MER being 50% for this example. It would be more accurate to say the Active Share MER is 45.25% since part of the $25,000 in fees would be the 0.25% cost on $950,000 of the portfolio is $2,375 (which you can’t really get for less). Therefore you divide the remaining $22,625 into $50,000 to get 45.25%.

Related posts:

1. Current Benchmarks for Active Management Are Too High
2. Active Funds Protect In A Down Market… Debunked
3. Growing Active ETF Market Means Mutual Funds Should Consider Allowing F-Class Units For Sale Through Discount Brokerages