Seeking Alpha – 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.