The High Cost of Active Investing

the high cost of active investingExpenses matter. A lot. Ninety-nine percent of investing is about dealing with unknowns – risk, returns, current events ­– but expenses make up that one percent where we actually know what will happen. It’s one area of investing you can actually control, which is why it’s so important to keep an eye on it.

Mutual funds are an acceptable place to put your money, but they’re not free. The cost comes directly out of your returns, so you want to make sure it’s as low as possible.

Mutual funds want to charge you as much as they can get away with. There’s nothing particularly wrong with this – they are businesses after all, and they want to make a profit.

But nobody wants to invest in funds with high expenses, and the mutual fund industry has started to hear this message pretty clearly.

The Investment Company Institute (which is the industry association for asset managers) looks at the average expense ratios every year, and over the last 20 years we can see expense ratios for both active and passive funds dropping rapidly:

Stock Funds Bond Funds Money Market Funds
1996 1.04% 0.84% 0.52%
2006 0.88% 0.67% 0.40%
2015 0.68% 0.54% 0.13%

As you can see, expense ratios have fallen significantly, but that’s just part of the story.

There’s a very clear division in the mutual fund industry between active funds that try to beat the markets, and index funds that simply harvest the returns the markets provide. While both active and index fund expenses have been coming down, active funds are significantly more expensive.

Active Index
Equity Bond Equity Bond
1996 1.08% 0.84% 0.27% 0.20%
2006 0.98% 0.69% 0.19% 0.17%
2015 0.84% 0.60% 0.11% 0.10%

Since there is no evidence that active funds outperform index funds, paying the higher fees of active managers is an unnecessary move. The average active stock fund (as of 2015) was nearly eight times as expensive as the average index stock fund. This is a massively huge burden to overcome.

Let’s look at an example to see what kind of impact we’re looking at: say you have  $1 million dollars you want to invest for thirty years, and you can invest in one of two funds:

  1. An active stock fund that charges 0.84% of your assets every year, and
  2. A passive stock fund that charges 0.11% per year.

To allow us to focus purely on the effects of the expenses, we’ll say both funds have the same 6% return every year. How much money will you have once the thirty years is up?

high cost of active management

Ending Portfolio Value Expenses Paid
Active Fund $4,459,349 $602,827
Passive Fund $5,556,948 $90,312
No Expenses $5,743,491

For illustration purposes only. Results do not represent the returns of any known investments, and are purely for illustrating the effects of investment expenses.

If you invested in the index fund, you would have ended up with $1,097,599 (or 24.61%) more after thirty years than if you invested in the active fund – even though the active fund “only” directly paid $512,515 more in expenses.

That might seem like my math is a little off, but it’s actually because of investment returns compound. Since the active fund paid more in expenses every year (meaning it had less money than the index fund), there weren’t as many dollars to grow in the next year. “Little” differences like that can really add up over an investment lifetime.

The point of investing is to keep your money working for you. Paying extra investment expenses means your money is working for the mutual fund company.

For more on making your money work for you, read our ebook



 

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