Cost intensity of active portfolio management

A fundamental question for stakeholders in the active management industry is what level of active management fee could be considered fair when factoring in the active risk deployed to generate the gross active return. To explore this topic, we introduce a new, simple and effective metric, the information ratio threshold (IRT), which reframes the fee signature of an active manager in terms of its cost intensity: the ratio between a fund’s fee and its tracking error volatility (TEV). Intuitively, the higher the cost intensity, the higher the bar for the investors to obtain a net (i.e., after fee) outperformance against the relevant benchmark, all else equal. We test the IRT on a sample of 3937 share classes belonging to 1230 active equity and bond funds in 14 main asset allocation categories. Our data confirm the intuition that the greater the IRT, the lower the net information ratio (IR) delivered to investors. We believe that our findings could support funds’ due diligence, product governance, and assessment-of-value considerations.