The HIgh Cost of Active Management
Financial Analyst John Bogle, founder of the Vanguard Mutual Fund Group, estimated in an upcoming paper that the total costs paid by investors in actively managed US funds is 2.25%. Those costs include portfolio turnover expenses, sales loads, operating expenses and advisory fees. Passively managed index funds, on the other hand, are now available at fees at and around five basis points for institutions and 20 basis points or less for individuals.
Controlling costs, and stemming the erosive effects they have on your gains, is crucial to return on investment. William F. Sharpe of Stanford demonstrated that different expense ratios in mutual funds had a profound impact on end-of-life wealth levels (Financial Analysts Journal, “The Arithmetic of Investment Expenses, March/April 2013). W.F. Sharpe explains that an investor saving for retirement with low-cost funds, controlling his models for plausible conditions, could have a standard of living 20% higher than that of a comparable individual using high-cost funds.
It is rare for investors to find high-cost, active managers that consistently shepherd portfolios to returns that appropriately overcome the cost burdens of the high-cost manager. And the burden from these active managers’ price-tag can be substantial. Bogle calculates that the compounding effects of these higher prices, over an investment lifetime of 50 years, can more than half investment returns. For example: assuming 7% gross returns, and costs of 2.25% an initial investment of $10,000 under active management would grow to $100,000 at an effective rate of 4.75%. An identical $10,000 investment under the same return parameters would grow to $268,000 with a passively managed fund with a cost of 0.2%, or net returns of 6.8%. That is an easily obtainable expense ratio for individual investor with a low-cost all-market index fund.
Managers with extraordinary skill exist but the basic arithmetic dictates that their high fees undermine the returns they deliver. Managers that exceed their benchmarks are rare and virtually impossible to identify in advance; they otherwise blend into the herd of the mediocre, and on an average annual basis are no more profitable for their clients than another. No wonder a steadily increasing number of investors are turning to a low-cost, passively managed index approach to support their investment efforts.