Cost and Benefit Comparison for Active vs. Passive Funds

Cost and Benefit Comparison for Active vs. Passive Funds

The cost spread between actively managed funds and indexed funds is not driven only by the  management fee that ostensibly pays for an advisor’s expertise. Other somewhat hidden costs also drive up the true price of an actively managed fund.

John Bogle, founder of Vanguard, recently wrote a paper called The Arithmetic of “All-In” Investment Expenses that every investor should read.  Here’s the simple math, excluding wealth management fees:

Active Fund

Index Fund

Index Advantage

Average Expense Ratio

1.12

.06

1.06

Transaction Costs (Fund Level)

.50

.00

.50

Cash Drag

.15

.00

.15

Tax Inefficiency

.75

.30

.45

Total

2.52

.36

2.11

From these figures, we can conclude that an active fund has to beat an index fund by quite a bit in order to justify the extra expenses. If fund managers can produce returns that trounce those of index funds – and we know that sometimes, they do – is that worth paying more for? If they consistently outperformed the index, the higher fees they charge would indeed be justified. Unfortunately, consistent outperformance is elusive.

At any given time, about 25 percent of active managers outperform the index. So, you just have to find a manager in that top 25 percent and stick with them, right? The problem is the composition of that top quartile changes yearly, so this year’s leader is probably not going to lead the pack next year.

Over the long run, the odds that your fund manager will reliably pick winners is about 1 in 20, according to a report by Vanguard. Those odds make it tough to justify paying fees of two percent annually. We’re not saying active management is never a good idea. In fact, under certain market and economic conditions, active funds can be excellent complements to an index-dominated portfolio. Nonetheless, the decision to delve into active management is complicated. Not everyone has the liquidity or the stomach to get value out of the relationship, so there’s a lot to keep in mind.

Patience Is Required

Research Affiliates concluded that even if investors managed to pick a true superstar manager, they would likely dump him before his worth is proven. That’s just human nature, our need for immediate positive reinforcement, and the short-term performance pressures placed on advisors.

Warren Buffett is a good example. His Berkshire Hathaway holding company is one of the most successful investments of the last half-century. Yet, Berkshire Hathaway underperformed more than four years at one point along its upward trajectory, too long for the risk tolerance of many investors.

Like most managed funds, Berkshire Hathaway has a high active share, meaning that unlike index funds, it is highly concentrated in certain sectors and companies and thus has a better chance of outperforming. The performance of highly concentrated portfolios tends to diverge from the index, which is how those funds sometimes beat indexes. But that’s also the reason so many investors won’t stick with them.

The best three US stock funds since 1970, which outperformed the index by more than 2% annualized, had long stretches of underperformance, ranging from 18 quarters to 23 quarters.  That’s half a decade!

The flip side of patience: If you had the stomach to stick with a manager for the long haul, a decade might pass before you would know you were in a losing fund. Ten years of management fees and expenses can really add up.

Before deciding on an active vs. passive strategy, it pays to do the math first.

 

Ben Johnson
ben@highlandprivate.com
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