The fee is only part of the bill. Trading and cash drag add more than a third on top, and tracking error decides how long the client waits to see any edge.
An active fund has to earn enough gross alpha to cover everything it costs over and above an index fund: its ongoing charge, the trading costs that sit outside the ongoing charge, and the drag of the cash it holds. On an illustrative equity fund with a 0.85 per cent ongoing charge, 60 per cent turnover and 3 per cent in cash, the hurdle is 1.12 per cent a year of gross alpha against an index fund costing 0.06 per cent. At a 4.0 per cent tracking error, that is an information ratio of 0.28 every year just to tie.
Worked in full in Asset Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most comparisons stop at the fee line: 0.85 against 0.05, so the manager needs 0.80 per cent. That figure understates the hurdle by more than a quarter, because the two largest costs that are not in the ongoing charge figure (OCF) are also the ones the factsheet does not show. The calculation below puts all of them in the same unit, per cent of assets a year, and then asks the harder question: even a manager who clears the hurdle, how often will the client see it?
| Input | Value |
|---|---|
| Active fund management fee | 0.75% |
| Other costs inside the OCF (administration, custody, audit) | 0.10% |
| Portfolio turnover a year | 60% |
| One-way trading cost (commission, spread, market impact) | 0.20% |
| Cash held by the active fund | 3.0% |
| Expected index return / cash return | 7.0% / 4.0% |
| Index fund OCF / trading and other tracking cost | 0.05% / 0.01% |
| Active fund tracking error | 4.0% |
1. Ongoing charge. 0.75% + 0.10% = 0.85%.
2. Trading cost. Turnover counts one side of the trade, so each turn of the portfolio is a sale and a purchase: 60% × 2 × 0.20% = 0.24%. In Excel: =Turnover*2*OneWayCost.
3. Cash drag. Cash the index fund does not hold earns the cash rate instead of the equity return: 3.0% × (7.0% − 4.0%) = 0.09%.
4. All-in cost of the active fund. 0.85% + 0.24% + 0.09% = 1.18%.
5. Less the index fund's own cost. 0.05% + 0.01% = 0.06%. Required gross alpha = 1.18% − 0.06% = 1.12%.
6. Required information ratio. 1.12% ÷ 4.0% = 0.28.
Check: the index fund returns 7.0% − 0.06% = 6.94%. An active fund with exactly 1.12 per cent of gross alpha returns 7.0% + 1.12% − 1.18% = 6.94%. They tie, as they should.
The fee-only comparison gives 0.85% − 0.06% = 0.79%, and understates the hurdle by 0.33 points. Trading and cash are 28 per cent of what the active fund really costs. Turnover is measured as in how to calculate portfolio turnover ratio; the one-way cost is the uncertain input, and for a small-cap or emerging market fund it can be several times 0.20 per cent.
| Gross alpha | Net return | Value after 10 years | Against the index fund |
|---|---|---|---|
| Index fund | 6.94% | $19,561,484 | 0 |
| 0.80% (looks skilled) | 6.62% | $18,983,959 | −$577,525 |
| 1.12% (break-even) | 6.94% | $19,561,484 | 0 |
| 1.50% (genuinely skilled) | 7.32% | $20,267,801 | +$706,317 |
A manager adding 0.80 per cent a year before costs is better than most at picking stocks. The client still ends up $577,525 behind on $10,000,000, because the skill is smaller than the bill.
Alpha is an average. In any given period the active fund's return differs from the index by its tracking error, scaled down by the square root of the number of years. If the manager's true net alpha is α and the tracking error is TE, the probability of beating the index fund over T years is roughly =NORM.S.DIST(alpha*SQRT(T)/TE,TRUE).
| Horizon | Gross alpha 1.50% (net +0.38%) | Gross alpha 0.80% (net −0.32%) |
|---|---|---|
| 1 year | 54% | 47% |
| 5 years | 58% | 43% |
| 10 years | 62% | 40% |
| 20 years | 66% | 36% |
This is the uncomfortable part. A genuinely skilled manager, net 0.38 per cent a year ahead, still trails the index fund over five years 42 times in a hundred. A manager who leaves the client behind the index fund after costs still beats the index in 43 five-year windows out of a hundred. A five-year record cannot tell the two apart. To be 90 per cent confident of the skilled manager's edge from the record alone would take about 182 years.
| Management fee | Turnover 20% | Turnover 60% | Turnover 100% |
|---|---|---|---|
| 0.50% | 0.71% (0.18) | 0.87% (0.22) | 1.03% (0.26) |
| 0.75% | 0.96% (0.24) | 1.12% (0.28) | 1.28% (0.32) |
| 1.00% | 1.21% (0.30) | 1.37% (0.34) | 1.53% (0.38) |
Every 40 points of turnover costs 0.16 per cent at a 0.20 per cent one-way cost, about the same as cutting the fee by 0.16 points. A high-turnover fund at a modest fee can need more alpha than a patient fund at a full fee. Tracking error works the other way on the ratio: the same 1.12 per cent needs an information ratio of 0.56 at 2.0 per cent tracking error, which is a closet tracker's problem, and only 0.19 at 6.0 per cent.
The usual error is to compare the active fund with the index rather than with the index fund, and to subtract only the fee. That gives a hurdle of 0.85 per cent, or 0.79 per cent against the index fund's charge, and ignores 0.33 points of trading and cash that the client pays whether or not they appear on the factsheet. The second error is to read a five-year outperformance as proof that the hurdle is cleared. With a 4.0 per cent tracking error, the record is mostly noise; the information ratio over a long run, worked in how to calculate tracking error and the information ratio, is the better test.
For a manager review: state the all-in cost, the required gross alpha and the information ratio it implies, before looking at the record. A manager who needs an information ratio above 0.3 every year is promising something few deliver.
Required gross alpha = OCF + turnover × 2 × one-way cost + cash weight × (equity return − cash return) − index fund cost. Here: 1.12 per cent, an information ratio of 0.28. The fee gap explains only 0.79 of it. The fees, the turnover and the cash of a real mandate are set out alongside the four return measures in the free workbooks for this book.
Its all-in cost less the index fund's cost. With a 0.85 per cent ongoing charge, 0.24 per cent of trading costs from 60 per cent turnover and 0.09 per cent of cash drag, the active fund costs 1.18 per cent a year. Against an index fund at 0.06 per cent, it needs 1.12 per cent of gross alpha simply to tie, not 0.79 per cent from fees alone.
Required gross alpha divided by tracking error. At 1.12 per cent and a 4.0 per cent tracking error it is 0.28 every year just to break even with the index fund. Long-run information ratios above about 0.3 are uncommon, which is why the cost side matters as much as the manager's skill.
Far longer than a review cycle. A manager 0.38 per cent a year ahead after costs, with 4.0 per cent tracking error, beats the index fund in only 58 per cent of five-year periods and 62 per cent of ten-year periods. Being 90 per cent confident from the record alone would take about 182 years.
This article is one calculation from Asset Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: corporate finance, valuation and markets → · All 1501 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.