MEASURING THE TRUE COST OF ACTIVE MANAGEMENT BY MUTUAL FUNDS

Ross M. Miller

This article derives a rigorous method for allocating fund expenses between active and passive management that enables one to compute the implicit cost of active management. Computing this active expense ratio requires only a fund’s published expense ratio, its R2 relative to a benchmark index, and the expense ratio for a competitive fund that tracks the index. This method is then applied to the Morningstar universe of large-cap mutual funds and active expense ratios are found to average nearly 7%. The cost of active management for other classes of mutual funds is also found to be substantial.