Every so often there’s a new study and accompanying article pointing out that actively managed mutual funds underperform their benchmarks. Frankly, nothing here is very surprising – it’s no great secret that mutual funds have been historically been beaten by their respective benchmark indices. This well-known dirty little secret is part of the reason ETFs have surged in popularity. Even alternative investment-based mutual funds appear to be suffering the same fate. Especially for cost-conscious registered investment advisers (RIAs), the lower cost of ETFs just makes sense. Why pay someone to make less money for you?

We work in a space where fees, from a surface level, can seem exorbitantly high to those unfamiliar with the space. Many an RIA has balked at the established 2 and 20 fee structure of the hedge fund and managed futures space during our conversations with them – the very same RIAs that have been part of this dash into ETFs. Now, we’ve defended this fee structure in the past, but with this most recent underperformance report, we found ourselves wondering what would happen if an RIA  tried to apply passive index investing logic to the rest of the actively managed world – things like hedge funds and managed futures. What if you put together a portfolio tracking indices which follow roughly the same markets as an active hedge fund or CTA manager? Who would win?  Is there a lower cost alternative to the 2 and 20 fee structure?

We took a simple approach, looking at a passive index of 33% bonds via the Citi World Bond Index, 33% stocks via the S&P 500, and 33% commodities via the Goldman Sachs Commodity Index for our “passive” portfolio.  Real managers are likely nowhere near such splits, but like we said, it’s a very simplistic proxy. We then compared that to the Dow Jones Credit Suisse Hedge Fund Index and the BarclayHedge CTA Index.

If you take the completely irresponsible and shallow reporting angle and look at returns only, you see following (Disclaimer: past performance is not necessarily indicative of future results.)

Not exactly a ringing endorsement for our passive portfolio, but looking at just returns is like considering a car based only on how fast it goes. You should probably also be concerned with whether brakes were installed or not, too. If we compare the passive versus active on a risk-adjusted basis, looking at both return over volatility ratios (Sharpe, using 0% as the risk free rate) and return over drawdown ratios (MAR), we see the active managers definitely outperforming over most of the time periods we examined:

That’s right – managed futures on a 10 year lookback have roughly 3 times better returns per unit of volatility, and roughly 10 times better returns per unit of drawdown (worst peak to valley loss) than the passive index approach to performance replication (albeit an admittedly simplistic approach). Past performance is not necessarily indicative of future results, of course, but the historical performance makes a pretty clear distinction between the low cost ETF route and supposedly high cost hedge fund and managed futures strategies. You may be able to get better performance at a lower cost using ETFs instead of mutual funds (and we firmly believe you will if just trying to match a stock index), but if you want risk-adjusted performance, you’re going to have to bite the bullet and pay your 2 and 20. You get what you pay for, right?