Active fund fees: how inflated are they?

New research reveals active fund fees are far too high for the value they add. So how much is active management actually worth?

Investors routinely pay substantial active fund fees, typically five to ten times more than passive alternatives. It's the equivalent of paying £7 or £8 for a pint of milk—but is this premium actually justified?

The academic case against high active fund fees has been building for nearly three decades. Now, groundbreaking research by Andrew Ang and Debarshi Basu delivers what may be the most devastating critique yet of how investors value active fund management.

Their paper, How Much Should You Pay for Alpha?, represents the culmination of a specific strand of academic research that began in the mid-1990s with pioneering work on utility-based portfolio evaluation. The findings suggest that even when active funds deliver genuine outperformance, investors should pay far less than current fee levels, which typically range from 0.75% to 1.25% annually compared to passive alternatives often costing just 0.07% to 0.20%.

Building on three decades of utility research

The intellectual foundations for this work trace back to Sandi Kandel and Robert Stambaugh's influential 1996 paper in the Journal of Finance, On the Predictability of Stock Returns: An Asset Allocation Perspective. This research introduced the revolutionary concept of using certainty equivalents and investor utility to evaluate investment decisions.

Rather than simply asking whether markets are predictable, Kandel and Stambaugh asked the more practical question: how much should investors be willing to pay for that predictability? Their methodology provided a template for moving beyond traditional performance metrics toward genuine economic value assessment.

John Campbell and Luis Viceira extended this approach in their seminal 1999 paper in the Quarterly Journal of Economics on dynamic portfolio choice. They demonstrated how risk aversion and certainty equivalents could optimise long-term asset allocation, incorporating the uncertainty that traditional metrics often ignore.

Ang and Basu have now applied this same utility-based framework to active fund selection, asking the crucial question: once you account for risk, correlation, and the investor's existing portfolio, how much genuine value does active management actually provide?

From market timing to fund selection

The progression from academic theory to practical application reflects decades of refinement in financial economics. Early work focused on whether markets could be timed or predicted. But as researchers developed more sophisticated tools for measuring investor welfare, attention turned to the more pressing question of how much investors should pay for various financial services.

A key milestone came in 2007 when William Goetzmann, Jonathan Ingersoll, Matthew Spiegel, and Ivo Welch published Portfolio Performance Manipulation and Manipulation-Proof Performance Measures in the Review of Financial Studies. This paper developed performance metrics grounded in investor utility, specifically designed to resist gaming by fund managers.

The authors recognised that traditional metrics like alpha could be manipulated through options strategies or other complex trades that improved headline performance while actually reducing investor welfare. Their utility-based approach provided a more robust foundation for evaluation.

Ang and Basu reference this work as an early effort to derive performance metrics from utility functions, though they take the crucial next step of calculating actual certainty equivalent values for fund selection decisions.

The total portfolio revolution

Perhaps the most important intellectual development underlying the new research is what academics call the "total portfolio approach". This concept, articulated in Andrew Ang's 2014 report on the Norwegian Government Pension Fund Global, starts with a reference equity-bond portfolio and assesses active strategies around it.

This represents a fundamental shift from traditional fund analysis, which typically evaluates active managers in isolation. Instead, the total portfolio approach recognises that investors don't hold single funds—they hold diversified portfolios where the marginal contribution of any additional holding depends critically on what they already own.

Ang and Basu adopt this same portfolio-first framework, computing the value of adding active funds relative to a diversified base portfolio. This explains why their results differ so dramatically from traditional alpha-based assessments: they're measuring incremental utility rather than standalone performance.

Utility theory meets practice

The theoretical foundation became increasingly practical through work by researchers and practitioners emphasising that uncertainty must be properly discounted. Victor Haghani and James White's 2023 book The Missing Billionaires provided a bridge between academic utility theory and real-world investment decisions.

Though more practitioner-oriented than traditional academic work, Haghani and White strongly emphasise that investors should value financial opportunities based on utility functions, not nominal returns or probabilistic outcomes. Their work reinforced the idea that impressive-sounding alphas mean little if they don't translate into genuine improvements in investor welfare.

Ang and Basu cite this book to reinforce their central thesis: that uncertainty must be discounted and that alpha should be evaluated through the lens of how it affects real investor utility, not just headline performance figures.

Methodology matters: Style factors and risk adjustment

The new research also builds on decades of work in performance attribution, particularly Mark Carhart's 1997 extension of the Fama-French model to include momentum factors. This four-factor model, covering market, size, value, and momentum exposures, has become the academic standard for measuring genuine alpha versus factor exposure.

By using style-factor adjusted alphas rather than simple market-relative performance, Ang and Basu ensure they're measuring genuine manager skill rather than systematic factor exposures that investors could access more cheaply through index funds.

This methodological sophistication matters enormously for investors globally. Many active funds that appear to generate alpha are actually providing exposure to well-known factors like value or small-cap stocks. The utility-based approach reveals that active fund fees are often unjustified when investors could obtain the same factor exposure elsewhere at lower cost.

Why active fund fees remain stubbornly high

The utility-based approach is finding increasing application across financial economics. Ang's recent work applying utility calculations to assess the cost of investing in risky or "decoupling" markets like Russia or China demonstrates the methodology's versatility beyond traditional fund evaluation.

This growing body of work suggests that utility-based valuation is becoming the gold standard for sophisticated investment analysis, moving beyond the simple risk-return metrics that dominated earlier decades.

The mathematics of overpriced active fund fees

When applied to fund management globally, this academic foundation produces uncomfortable conclusions. The research suggests that even funds delivering genuine alpha justify fees of only around 19 basis points on average, far below the 75-125 basis points typically charged by active managers worldwide.

The academic evidence helps explain widespread outflows from active funds in major markets. As institutional investors and sophisticated advisers increasingly adopt utility-based evaluation frameworks, traditional performance metrics lose their persuasive power.

This shift reflects a broader maturation in investment analysis. Early academic work focused on whether active management could work in theory. Contemporary research asks the more practical question: given that it occasionally works, how much should investors pay for it?

Evidence-based regulation gains ground

The academic foundation also provides intellectual support for regulatory initiatives globally. Regulators increasingly push fund groups toward greater transparency about value for money, aligning with academic evidence that traditional performance metrics often mislead investors about genuine value creation.

This convergence between academic theory and regulatory practice suggests that pressure on active management fees will continue mounting. When both university researchers and government regulators reach similar conclusions through different methodologies, industry practices face powerful challenges.

A paradigm shift in investment evaluation

The Ang-Basu research represents more than another critique of active management. It exemplifies a fundamental shift in how sophisticated investors evaluate financial services. Moving from performance-based to utility-based assessment changes everything about fund selection and fee justification.

For investors globally, this academic foundation provides powerful tools for challenging fund marketing claims. When active fund fees consistently exceed what rigorous utility analysis suggests funds are worth, the mathematics become difficult to ignore.

The academic evidence is clear: after three decades of increasingly sophisticated analysis, the case for high active fund fees has never been weaker. Investors armed with this knowledge are unlikely to accept traditional industry justifications for much longer.

The revolution in investment evaluation may have started in academic journals, but its implications are reshaping fund management worldwide.

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