What is the True Cost of Active Management? A Comparison of Hedge Funds and Mutual Funds

Abstract

On the surface, hedge funds seem to have much higher fees than actively managed mutual funds. However, the true cost of active management should be measured relative to the size of the active positions taken by a fund manager. A mutual fund combines active positions with a passive position in the benchmark index, which can make the active positions expensive. A hedge fund takes both long and short positions and uses leverage, which makes the active positions cheaper, but this can be offset by the expected incentive fees, especially for more volatile funds. We investigate the trade-offs from the perspective of a fund investor choosing between a mutual fund and a hedge fund, examining the impact of leverage, volatility, Active Share, nominal fees, and alpha for a realistic range of parameter estimates. Our calibration shows that a moderately skilled active manager is approximately equally attractive to investors as a mutual fund manager or as a hedge fund manager, showing that both investment vehicles can coexist as efficient alternatives to investors. Further, our model explains documented empirical findings on career development of successful fund managers and on hedge funds' risk taking. Finally, we show that our findings are quite robust with respect to a jump risk in the hedge fund returns.