Active return gap: Meaning, Criticisms & Real-World Uses

What Is Active Return Gap?

Active return gap refers to the difference between an actively managed investment's gross return and its net return. It is a key metric within investment performance measurement, highlighting the impact of fees and expenses on an investment portfolio's overall performance. A positive active return gap indicates that the gross return, before costs, was higher than the net return, after accounting for all charges.

The active return gap quantifies the drag that various costs, such as management fees, trading costs, and administrative expenses, exert on a fund's ability to outperform its benchmark index. Understanding this gap is crucial for investors evaluating the true value added by a portfolio manager. The concept emphasizes that for active management to be truly beneficial, the gross return must significantly exceed the benchmark, enough to cover all expenses and still deliver a superior risk-adjusted return.

History and Origin

The concept of evaluating investment performance net of fees has always been inherent in financial analysis, but the formal emphasis on the "active return gap" gained prominence with the increasing scrutiny of active management versus passive management strategies. As the investment management industry grew, particularly with the proliferation of mutual funds and Exchange-Traded Fund (ETF)s, the impact of costs on investor returns became a focal point.

Academic research and industry reports increasingly highlighted that a significant portion of active funds struggled to consistently beat their benchmarks after fees. For instance, the Morningstar Active/Passive Barometer, a semiannual report, frequently measures the performance of active funds against comparable passive funds, often concluding that a majority of active funds underperform their passive counterparts, particularly over longer time horizons, and that higher costs contribute to this underperformance.⁸,⁷ Similarly, the SPIVA (S&P Indices Versus Active) Scorecard, produced by S&P Dow Jones Indices, has for over two decades consistently documented how a substantial percentage of actively managed funds fail to outperform their respective benchmarks, especially when considering fees.⁶,⁵ This ongoing evidence underscores the importance of the active return gap, as it directly illustrates the magnitude of the performance hurdle created by investment costs.

Key Takeaways

The active return gap measures the difference between an investment's gross return (before fees) and its net return (after fees).
It quantifies the total cost of managing an investment, including management fees, trading expenses, and administrative overhead.
A larger active return gap implies higher costs, which can significantly erode the potential for an actively managed fund to outperform its benchmark.
For active management to be considered successful, its gross return must be sufficiently high to overcome this gap and still deliver superior net performance.
Investors utilize this metric to assess the true value added by a fund manager after all expenses are considered.

Formula and Calculation

The formula for the Active Return Gap is straightforward:

\text{Active Return Gap} = \text{Gross Return} - \text{Net Return}

Where:

Gross Return: The total return generated by an investment portfolio before the deduction of any fees, expenses, or taxes. This reflects the portfolio manager's raw ability to select securities or time the market.
Net Return: The total return generated by the investment portfolio after the deduction of all fees, operating expenses, and other charges. This is the actual return realized by the investor.

The active return gap essentially represents the cumulative impact of an expense ratio and other trading-related costs over a specific period. For example, if a fund generates a gross return of 10% and its net return to investors is 8%, the active return gap is 2%.

Interpreting the Active Return Gap

Interpreting the active return gap involves understanding what the difference between gross and net returns signifies for an investment strategy. A narrow active return gap suggests that the fund's fees and expenses are relatively low, allowing more of the gross performance to translate into net returns for the investor. Conversely, a wide active return gap indicates that a significant portion of the gross return is consumed by costs.

From an investor's perspective, a fund needs to generate a gross return that is not only positive but also substantially higher than its benchmark's return by an amount that comfortably covers its active return gap. If a fund's gross return matches its benchmark, but it has a non-zero active return gap, its net return will necessarily trail the benchmark. This highlights why high fees can make it challenging for even skilled managers to deliver alpha, or excess return over the benchmark, on a net-of-fees basis. Investment professionals often use this metric to scrutinize the efficiency of a fund's operations and the fairness of its cost structure in relation to the value proposition of active management.

Hypothetical Example

Consider Fund A, an actively managed equity fund, and its benchmark, a broad market index.

Scenario:

Fund A's Gross Return: Over one year, Fund A's portfolio management team generates a 12% return before any fees or expenses are deducted.
Fund A's Total Fees and Expenses: These aggregate to 1.5% of assets under management for the year.
Fund A's Net Return: This is calculated as the Gross Return minus the Total Fees and Expenses: 12% - 1.5% = 10.5%.
Benchmark Index Return: The broad market index that Fund A aims to outperform achieves a 10% return for the same period.

Calculation of Active Return Gap:
Active Return Gap = Gross Return - Net Return
Active Return Gap = 12% - 10.5% = 1.5%

Interpretation:
In this example, Fund A had an active return gap of 1.5%. While the fund's gross return (12%) successfully beat its benchmark (10%), its net return (10.5%) also managed to outperform the benchmark. The 1.5% active return gap represents the hurdle the fund had to overcome due to its operational costs. This demonstrates that even with a significant active return gap, a fund can still deliver alpha to investors if the gross performance is strong enough.

Practical Applications

The active return gap is a critical metric for both fund managers and investors in several practical applications:

Fund Evaluation: Investors use the active return gap to assess the efficiency of a fund's operations and the impact of costs on its ultimate performance. A transparent presentation of gross versus net returns, as encouraged by regulatory bodies like the U.S. Securities and Exchange Commission (SEC), helps investors understand the full cost of active management. The SEC's marketing rule requires investment advisers to present net performance alongside gross performance with equal prominence in advertisements, particularly for time periods of one, five, and ten years.⁴,³ This rule aims to ensure that investors have a clear picture of returns after all deductions.
Performance Attribution: For portfolio managers, dissecting the active return gap helps in performance attribution by isolating the contribution of investment decisions (gross return) from the impact of expenses. It can highlight whether underperformance relative to a benchmark is due to poor investment choices or excessive fees.
Fee Structure Analysis: Fund companies analyze the active return gap to determine appropriate fee structures. If the gap is too large, it might deter investors, especially when competing with low-cost passive management options.
Regulatory Compliance and Disclosure: Financial regulators require clear disclosure of fees and their impact on returns. The active return gap implicitly reinforces the importance of such disclosures, as it directly quantifies the difference between theoretical and actual investor gains.

Limitations and Criticisms

While the active return gap provides valuable insight into the cost burden of an investment, it has certain limitations and is subject to criticism.

One primary criticism is that it focuses solely on costs, without fully incorporating other aspects of risk-adjusted return. For instance, an active fund might have a wide active return gap due to higher trading activity (which incurs costs) but might also generate superior returns in less efficient market segments or during volatile periods, showcasing the manager's skill. However, academic research has frequently investigated the impact of scale on active management, with some studies suggesting decreasing returns to scale at the industry level, meaning that as the active mutual fund industry grows, a fund's ability to outperform passive benchmarks may decline.² This implies that even if skill increases, the growing size of the active management industry can make it harder for active managers to overcome their costs and deliver consistent alpha.

Moreover, the active return gap doesn't differentiate between various types of expenses. Some expenses, like trading costs, are variable and depend on the portfolio manager's strategy, while others, like administrative fees, are relatively fixed. A high active return gap due to legitimate, performance-enhancing trading, compared to one due to inflated administrative costs, requires different interpretations. The persistent challenge for active managers to beat passive benchmarks, as detailed in reports like the SPIVA Scorecard, suggests that the active return gap often proves to be an insurmountable hurdle for many funds over the long term, making it difficult to justify their higher fees compared to strategies focused on diversification and market exposure.¹

Active Return Gap vs. Tracking Error

While both active return gap and tracking error are metrics used to evaluate actively managed investments against a benchmark, they measure distinct aspects of performance.

The active return gap quantifies the cost associated with managing a portfolio by measuring the difference between its gross return (before fees and expenses) and its net return (after fees and expenses). It directly illustrates how much of the gross return is consumed by operational costs, and therefore, how much higher a fund's gross return must be than its net return.

In contrast, tracking error measures the volatility of the difference between a portfolio's returns and its benchmark's returns. It is a measure of risk, indicating how consistently an actively managed fund deviates from its target index. A high tracking error suggests significant deviations from the benchmark, which could imply either a highly active strategy or a less predictable one. It does not directly quantify the impact of fees but rather the degree of active bets taken by a portfolio manager.

In essence, the active return gap addresses the "take-home" return after costs, while tracking error addresses the "how much did the manager deviate from the index" aspect of risk. A fund could have a low tracking error (meaning it closely follows its benchmark) but a significant active return gap (meaning high fees are eating into its slight outperformance). Conversely, a fund with a high tracking error might generate substantial gross alpha but still struggle to deliver positive net alpha if its active return gap is too wide.

FAQs

What does a high active return gap indicate?

A high active return gap indicates that a significant portion of the returns generated by a fund's underlying investments is consumed by fees and expenses. This makes it more challenging for the fund to deliver strong net returns to investors, especially when compared to a benchmark index.

Is a smaller active return gap always better?

Generally, a smaller active return gap is preferable as it means more of the gross return translates into net return for the investor. However, a slightly larger gap might be acceptable if it is demonstrably linked to a strategy that consistently generates substantial alpha that more than compensates for the higher costs.

How does market efficiency relate to the active return gap?

In highly market efficiency markets, such as large-cap U.S. equities, it becomes more difficult for active managers to consistently find mispriced securities and generate high gross returns. In such environments, a wide active return gap due to high fees can make it exceedingly difficult for active funds to outperform passive alternatives on a net basis, reinforcing the case for lower-cost passive management.

Can an actively managed fund still be worthwhile with a noticeable active return gap?

Yes, an actively managed fund can still be worthwhile if its gross returns consistently and significantly exceed those of its benchmark by an amount that more than covers the active return gap. This demonstrates true portfolio manager skill in security selection or market timing, leading to superior net returns for the investor.