Costs of active management

03Oct06

One thing we try to do here at Abnormal Returns is take a step back from the everyday fray of the market to try and provide a modicum of perspective on relevant issues facing investors. One thing we are struck by is the fact that the entirety of the financial press, blogs included, is focused on providing information and analysis focused on “beating the market.” We include ourselves in that group considering the title of this blog.

Rarely, however, do we see the costs of pursuing active returns, both explicit and implicit, considered alongside the opportunity. Let us for a moment consider the various costs involved in active management. By active management we mean any portfolio management approach which seeks to outperform a benchmark. This would include actively managed mutual funds (open-end and closed-end), certain new “quasi-active” ETFs, separately managed accounts, hedge funds, and maybe most relevant for this discussion self-managed portfolios of individual securities.

Some costs are obvious. These include the management fees on third-party funds. For things like hedge funds we would also include the incentive fees. Other explicit costs include: data, publications, newsletters. For the individual investor we should also include costs like commissions, account fees, etc. There are, of course, implicit costs as well. The time required to stay up-to-date, including time reading blogs like this, watching the market (and CNBC). Maybe the most neglected aspect is in fact, search costs. The time and effort spent seeking out profitable investment opportunities. Once a promising investment is found a prudent investors will also spend time (and money) in conducting due diligence. After an investment is made one also needs to monitor said investment in order to facilitate an eventual exit.

We have surely missed (and omitted) some costs for the sake of brevity, but the point should be clear. Active management requires an investment of time and effort to be done thoroughly. For some individuals the actual time is not viewed as wasted, in the sense that the process is in fact enjoyable on a certain level – which is great. For others time spent on investments is as enjoyable as time spent in a dentist’s chair. The bottom line is that we should all be aware that active management entails both the risk of underperformance as well as the certainty of time spent.

For example, Jane J. Kim in the Wall Street Journal reports on a new online stock research service from the Motley Fool crew that wants to serve as a clearing house for stock picks. One the face of it this sounds great, but on further inspection it is a potential trap for investors. Well-grounded investors focus not on performance, per se, but rather on process. Undoubtedly some stock pickers, professional and amateur, will emerge from this process, but without a firm understanding of their investment approach including the risks involved, a performance number is essentially worthless. In addition, the time required to ascribe true “statistical significance” to any stock picker’s performance is unlikely to fit within any sort of reasonable time frame.

One active manager who has received a great deal of acclaim for his enviable track record is Bill Miller, the portfolio manager of the Legg Mason Value Trust (LMVTX). For those living under a rock Miller’s fund has bested the S&P 500 on a calendar year basis since 1991. While the streak is likely to end this year Tim Middleton at MSN Money asks a more fundamental question. What is the right price, in terms of management fees, for active management?

At least historically whatever Legg Mason charged for the fund was worth it, but as the performance begins to lag a high expense ratio seems all the less defensible. In a world of hedge funds charging “2 & 20″ there seems to be little stopping some investors from seeking out performance at any cost. The point is not that any particular management fee structure is appropriate, but rather one has to take into account the context in which it is charged and the risks involved. Even the best managers eventually stumble.

Newer funds may not have the track record of a Bill Miller, but that does not means they should be ignored. New fund managers face some drawbacks, including higher costs, but those may be offset by their ability to manage smaller amounts of capital, more nimbly. One area where individual investors may have an advantage is in getting in on the ground floor of promising new mutual funds. For instance, the Annex over at FundAlarm.com does a nice job of analyzing the prospects of new mutual funds. In addition, articles like the one by Lyneka Little in the Wall Street Journal also provide some insight into up-and-coming funds. There are of course no guarantees but they can provide a head start on your research process.

Nothing written above should necessarily dissuade you from your chosen investment strategy. It is meant to provide a little perspective on the various costs, both explicit and implicit, inherent in active portfolio management. Active management requires both an assumption of risk and an investment of time, the challenge is knowing how much of both you are assuming along the way.

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