When I'm choosing between brand-name Aspirin and the generic alternative, I almost always opt for the latter. Both share the same major ingredients, but the generic competitor is usually a lot cheaper. I'd pay a small premium if the brand-name product is longer lasting, easier on my stomach, or more effective. A superior alternative without a generic rival may be worth a higher price.
Fund investors face a similar choice between active and passive management. Many active managers fear impatient investors (or employers) will fire them if they underperform by limiting the risks they take versus their benchmarks. As a result, active and passive portfolios are made of similar ingredients. If the portfolios look alike, the cheaper, passive option appears to be the easy choice.
Not every choice is as simple. Nominally active funds could still stand decent odds against their benchmarks if their price tag is low enough. Higher-cost funds may yet outperform if their portfolios are distinctive enough. Fees are the most reliable guide to a fund's prospects, but investors should consider not only what they're paying but what they're getting. As Warren Buffett put it: "Price is what you pay. Value is what you get."
"Active cost," a concept developed by academics Martijn Cremers and Quinn Curtis, is one way investors can quantify the bang they get for their actively managed buck. The measure compares a fund's management-expense ratio (less the cost of the passive alternative) to its active share.
Active share describes how different a portfolio is from its benchmark. (Cremers introduced active share along with Antti Petajisto in 2007.) The higher its active share, the less a fund looks like its benchmark. A fund that replicates 75% of its benchmark's holdings would have a 25% active share, for example, while a fund with 25% overlap would have a 75% active share. If both funds have 1% MERs, the latter offers better value per unit of active management.
I've calculated active cost across the Canadian Equity category using the MER of each fund's lowest share class -- almost always the commission free, fee-based series. Many investors hold the more expensive commission-based series, but I wanted to exclude advice and distribution costs from the mix. I used the Morningstar Canada Index as my active share benchmark. (Click here to view a table of all funds studied.)
Take RBC Canadian Equity, for example. At first blush, its 0.95% MER appears reasonable next to the 1.11% median for its fee-based distribution channel. But the fund's largest holdings resemble those of its benchmark, the S&P/TSX Composite Index, resulting in 29% active share -- one of the category's lowest. As a result, its active cost of 3.2% ranks among the category's highest. This number implies that management needs to wring 3.2 percentage points of added value from a small slice of the portfolio to overcome its fee hurdle. Low-cost passive funds like 
iShares Core S&P/TSX Capped Composite Index (XIC ), which has a 0.06% MER, are a better bet.
By contrast, the 1.4% MER of Pender Canadian Opportunities makes it one of the most expensive Series F funds in its category. But lesser known stocks like Medicure Inc. (MPH) and Absolute Software Corp. (ABT) headline its portfolio, giving it the group's second highest active share of 90%. With an active cost of 1.5%, the fund looks like a better deal than its RBC peer. Also, with its tiny $5.8-million asset base, the Pender offering enjoys far more flexibility than its $2.5-billion RBC rival.
Active cost also can help investors weigh competing factor-based, or "smart beta" strategies and compare them to traditional actively managed funds. These funds tilt their portfolios toward factors historically associated with above-average returns, such as size, value, volatility or momentum.
Sometimes this tilt is modest. DFA Canadian Core Equity and iShares Canadian Fundamental Index (CRQ) each favour stocks with low valuations, but with active shares of 26%, they still look a lot like the benchmark. With almost identical active shares, it's easy to spot which option provides more active share for the buck. The DFA fund's 0.34% MER clocks in well below the iShares ETF's 0.73% levy. But the more expensive iShares offering is still a better buy than the even pricier RBC Canadian Equity.
As a snapshot in time, active cost often paints an incomplete picture. The active share of PH&N Vintage stands at 48%, but it has typically fluctuated from 40% to 60%. Knowing when to make active bets has contributed to management's strong long-term record. With a middling 1.14% MER, the fund's current active cost of 2.3% is somewhat high by category standards. But competitors with lower active costs probably won't replicate the PH&N offering's process. The apparently better value may be a mirage.
Of course, active cost is only one way to assess value. Other attributes matter too. A fund without capable management and a sound process isn't much of a value at all.
