Jack Vogel on how understanding ‘active fee’ and ‘underlying portfolio’ will help investors make more informed investment decisions
During a MarketWatch panel on smart-beta earlier this year, a variety of issues were discussed regarding smart beta. Two of the issues I discussed warrant further explanation: active fees and portfolio construction.
Investors can purchase U.S. equity ETFs (i.e. the S&P) for very little — 3 to 5 basis points. The minute an investor branches off into the world of portfolios that aren’t market-capitalization weighted, often labeled “smart beta,” these investors will be asked to pay a higher fee for this “smarter,” or active, portfolio.
Ideally, the premium paid for the active management is justified because the strategy is unique, but how unique is the active strategy? If a strategy is essentially a clone of the S&P 500, then a 10 basis point management fee is expensive, whereas if the strategy is dramatically different than the S&P 500 a fee of 100 basis points may be justified.
Unfortunately, simply comparing expense ratios across funds is an exercise in comparing apples to oranges. However, “active fee” is a concept that helps investors facilitate an apples-to-apples cost comparison and an important component to consider when buying smart-beta products based on the academic research findings.
To better understand the active fee of a portfolio, one first needs to assess how active the ETF is relative to a market-cap weighted index. One way to do this is by computing the “active share” which measures how active an ETF is relative to the market-cap weight index.
An ETF can have an active share between 0% and 100%, with 100% being “most active” and 0% being the market-cap weight index. So, a smart-beta ETF with an active share of 10% is essentially 90% the market, and 10% an active “factor” portfolio.
One way to calculate the “active fee” of an ETF is to use the active share calculation. To calculate the active fee, let’s assume the cost of a market-cap weighted portfolio is essentially free to make the math easier. Assuming the market-cap weight index is free (0.00%), we figure out the active fee by dividing the management fee by the active share.
How does this work in practice? Let’s assume we have two investment options — smart-beta ETFs A and B that charge 0.30% and 0.80% management fees, respectively. Simply examining the management fees, A is much cheaper!