Fees: Six of one or half-dozen of the other.

Fees 11 Aug 2008

Pop Quiz: Which are more expensive, hedge funds or mutual funds?

Sounds like a pretty dumb question, right?  Well as regular readers will know, this question is actually central to our views here at AAA.  Over two years ago, we told you about an academic study called “Measuring the True Cost of Active Management by Mutual Funds” by Ross Miller of the State University of New York.  Miller argued that since mutual funds could be largely replicated by low-cost index funds or ETFs, the implicit fee for their active management was significantly higher than the posted expense ratios.  For good reason, the paper was subsequently included in the Q1 2007 edition of the Journal of Investment Management.

The latest to make this argument is Mark Kritzman of Windham Capital.  In his article “Who Charges More: Hedge Funds or Mutual Funds?” (Winter 2008 Journal of Applied Corporate Finance) Kritzman says:

“Hedge funds, in principle, hedge out market returns and thereby produce a pure alpha; hence the term hedge fund. Alpha, in principle, is uncorrelated with market returns. Mutual funds, by contrast, generate returns that comprise a market component and an alpha component. The returns of mutual funds are typically more than 95% correlated with market returns. Taking these factors into account, it is unclear whether hedge funds or mutual funds are more expensive.”

Sceptics of this argument will immediately point out that a lot of hedge funds do not actually deliver “pure alpha”.  But that is not a central requirement of Kritzman’s (or Miller’s) argument.

He illustrates his point using an example of fraternal twins who share the exact same stock picking style and skill.  One manages a mutual fund while the other deploys her skills in the form of a hedge fund (investing all capital at the at the risk free rate, shorting the index and using the proceeds to go long her favorite stocks).

He then compares the fees of the mutual fund to a combination of an index fund (at 5bps) and the hedge fund.  Since the “hedge fund” was itself created by shorting the index and going long the mutual fund – no new stock picking skill is introduced in this example.

As you might guess, the total fees (2% and 20% performance fee) paid on the “hedge fund” are basically the same – in fact, even a little less, than the overall fees paid for the mutual fund.

Kritzman provides several caveats including the differentials between the risk free rate and the rate implied in the costs of shorting.  But the conclusion is the same, he says.

“We are comparing apples to oranges when we measure the fees of a hedge fund that delivers a pure alpha stream with the fees of a market driven mutual fund…hedge fund fees and mutual fund fees are remarkably similar when measured properly. Or perhaps it is not at all remarkable, but rather what efficient markets dictate.” (our emphasis)

After we read Miller’s paper in 2006, we applied a modified version of his analysis to a set of 30 large equity mutual funds over the period January 1, 2000 to September 30, 2006.  We calculated the fee for the active component (what we called the “embedded hedge fund”) for each fund.  Then we determined a variety of combinations of fixed management fee and performance fees that would yield this overall fee.  When we fixed the management fee for the sample at 2%, guess what the corresponding performance fee was: 20%.  So the mutual funds were, in essence charging “2 and 20” for their services.

As Kritzman suggests, this is exactly what you’d expect “efficient markets” to dictate.

(Ed: If you want to read Kritzman’s article, do it now.  As of today, it’s not yet available on the Windham website and the JACF is only offering it as part of a “sample issue” at the moment.)

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