Hence, we can say that IVE = 58% IVV + 42% X. This also means that 0.157% of the 0.18% fee is associated with our active bets, X. (We calculate this as 0.18% – 0.04% x 58%.)
If we take 0.157% and divide it by 42%, we get the implicit fee that we are paying for our active bets. In this case, 0.373%.
So now we have to ask ourselves, “do we think that a long/short equity portfolio can return at least 0.373%?” We might want to dive more into exactly what that long/short portfolio looks like (i.e. what are the actual active bets being made by IVE versus IVV), but it does not seem so outrageous. It passes the sniff test.
What if IVE were actually 0.5% instead? Now we would say that 0.477% of the 0.5% is going towards our 42% position in X. And, therefore, the implicit amount we’re paying for X is actually 1.13%.
Am I confident that an equity long/short value portfolio can clear a hurdle of 1.13% with consistency? Much less so. Plus, the fee now eats a much more significant part of any active return generated. E.g. If we think the alpha from the pure long/short portfolio is 3%, now 1/3rd of that is going towards fees.
With this framework in mind, it is no surprise active managers have historically struggled so greatly to beat their benchmarks. Consider that according to Morningstar[5], the dollar-weighted average fee paid to passive indexes was 0.25% in 2000, whereas it was 1% for active funds.
If we assume a very generous 50% active share for those active funds, we can use the same math as before to find that we were, in essence, paying a 1.75% fee for the active bets. That’s a high hurdle for anyone to overcome.
And the closet indexers? Let’s be generous and assume they had an active share of 20% (which, candidly, is probably high if we’re calling them closet indexers). This puts the implied fee at 4%! No wonder they struggled…
Today, the dollar weighted average expense ratio for passive funds is 0.17% and for active funds, it’s 0.75%. To have an implied active fee of less than 1%, active funds at that level will have to have an active share of at least 30%.[6]
Conclusion
As the ETF fee wars rage on, and the fees for standard benchmarks plummeting on a near-daily basis, the only way an active manager can continue to justify a high fee is with an exceptionally high active share.
We would argue that those managers caught in-between – with average fees and average active share – are those most at risk to be disintermediated. Most investors would actually be better off by splitting the exposure into cheaper beta solutions and more expensive, high active share solutions. Bar-belling low fee beta with high active share, higher fee managers may actually be cheaper to incorporate than those found the middle of the road.
The largest problem with this approach, in our minds, is behavioral. High active share should mean high tracking error, which means significant year-to-year deviation from a benchmark. So long as investors still review their portfolios on an itemized basis, this approach runs the risk of introducing greater behavioral foibles than a more moderated – yet ultimately more expensive – approach.
Corey Hoffstein is the Co-founder & CIO at Newfound Research, a participant in the ETF Strategist Channel.
[1] https://blog.thinknewfound.com/2017/10/frustrating-law-active-management/
[2] https://twitter.com/choffstein/status/880207624540749824
[3] Perhaps it is “examples” all the way down.
[4] See https://tools.alphaarchitect.com
[5] https://corporate1.morningstar.com/ResearchLibrary/article/810041/us-fund-fee-study–average-fund-fees-paid-by-investors-continued-to-decline-in-2016/
[6] We are not saying that we need a high active share to predict outperformance (https://www.aqr.com/library/journal-articles/deactivating-active-share). Rather, a higher active share reduces the implicit fee we are paying for the active bets.