The High Costs of Actively Managed Funds

51% of active stock managers beat the Russell 1000 during the third quarter of 2013. It was the first time since the first quarter of 2012 that the majority managers beat the benchmark. The third quarter performance of active managers compares favorably to the 2013 year-to-date results where only 39% have managed to outperform the benchmark.

This was a good quarter for active funds. The average margin of outperformance came in at 0.7%, according to Morningstar, the mutual-fund research firm.

Why is this 0.7% quarterly outperformance so significant? Most equity mutual-fund managers are charging investors annual management fees anywhere between 0.7% to 1.5% and a sales load as high 5.75%. Hedge funds typically charge 2/20, a 2% fee plus 20% of performance. So, while stock picking appears to have at least temporarily made a return from the wilderness, basic mathematics remains lost at sea.

Index funds, which passively follow the makeup of a market index without making active investment decisions, have a huge cost advantage over their actively-traded counterparts. Many funds that are indexed to the S&P 500, for example, have annual expenses of less than 0.1%.

For that extra expense, active managers are supposed to provide investors the benefits of the manager’s expertise in both stock selection and timing. Unfortunately, many actively-managed stock funds invest so closely to their particular index that their portfolios and returns are practically indistinguishable from their benchmark, according to Morningstar. That leaves investors in those funds with the worst of all possible worlds: They get an index fund but with the high cost of an actively managed fund.

Morningstar states that fund companies have an incentive to hug the indices in order to avoid underperforming them and losing customers. But, why pay high fees for active funds that are closet indexers?

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