Do low-cost “passive” funds really have a performance advantage over higher cost “actively managed” funds in the long term? It seems counterintuitive, but according to Nobel Prize winner William F. Sharpe and low-cost passive fund pioneer John C. Bogle, the answer is “yes.” And we’re not talking just a percentage point here or there either. Here’s where ground-breaking research from the ivory tower intersects with the real world, and can have a significant impact on the size of your retirement nest-egg.
Dr. Wm. F. Sharpe introduced Modern Portfolio Theory (MPT) in 1970, which was so ground-breaking in the world of finance that he was awarded the Nobel Prize for Economics in 1990. It took that long for the finance community to recognize and fully accept MPT for the ground-breaking work it was.
Zen and the art of portfolio management
Under MPT, Sharpe advised portfolio managers to manage the collection of securities as a whole – as a portfolio – rather than as discrete holdings that did not affect one another on an inter-security level. For the first time ever, Sharpe made investment managers think about correlations and covariances among the holdings – that the whole is more than the sum of its parts – and the portfolio management world has never looked back.
Bill Sharpe believed in efficient markets – that it’s not possible to identify mispriced securities and consistently exploit their price differentials for a net profit. Believed, and still believes: He is currently professor emeritus of finance at Stanford University, where he still teaches after 43 years.
As an efficient market proponent, Sharpe has long argued in favor of low-cost investments (i.e., “passive management,” or “index funds”). He wrote on the subject in 1966, 25 years later in 1991, and once more in 2013. Here’s the quote that resonated for me from “The Arithmetic of Active Management” (Sharpe 1991). It’s a bit long, but worth the read:
“Statements such as [“the case for passive management rests only on complex and unrealistic theories of equilibrium in capital markets”] are made with alarming frequency by investment professionals. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.
“If ‘active’ and ‘passive’ management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required…”
Costs are the determining factor
Not being as erudite as Sharpe, I provide my own crude summary of what I get from his quote. If the returns from active and passive management are equal before costs are considered, and active managers have higher costs, active management returns must be lower than passive management returns. Or, more bluntly, you make smaller return on active funds than you do on passive funds. So passive funds are the way to go.
Back to Sharpe for a minute: “…The proof is embarrassingly simple and uses only the most rudimentary notions of simple arithmetic.” Wow! What a slam against actively managed funds.
Bogle: costs underestimated
John C. Bogle has grabbed this same baton over the years and recently took another run with it. Bogle founded the Vanguard Group in 1974, which introduced low-cost mutual funds to the market. Vanguard just entered the Canadian market, slashing costs for investors here. Not just a supporter of Sharpe’s work, Bogle argues that Sharpe’s studies underestimate the gap in favor of low-cost investments.
To broad-brush it, Sharpe considered the difference only in expense ratios of active versus passive funds in his studies. In the January/February 2014 edition of the Financial Analysts Journal, "The Arithmetic of All-In Investment Expenses," Bogle considers not only expense ratios but also fund transaction costs, sales loads, and cash drag.
Transaction, cash drag, sales costs add up
Fund transaction costs include brokerage commissions and spreads. One study identifies these as costing 39 basis points (bps). Add in timing delays, market impact, etc., and this performance drag is estimated to cost 60 basis points annually. A separate study calculated average annual trading costs at 144 basis points, which is actually more than the 119 bps for the average annual expense ratio. Bogle settled on a haircut of 50 bps to keep his estimate conservative.
Cash drag is a phenomenon of active funds, which fairly consistently carry about 5% of their portfolio in cash. By contrast, index funds are almost always fully invested, and thus gain the equity premium for stocks over cash on that 5%. Thus the cash drag of the 5% is a cost for active funds in terms of foregone returns. Bogle uses a cost of 15 bps for the cash holdings of active funds.
The other “all-in” cost incorporated by Bogle in his study is sales loads – the cost of distribution of the fund paid by investors. Almost never taken into account, they nevertheless represent a significant cost borne by retail investors, averaging about 8% of the dollar amount purchased from 1924 through the late 1970s (i.e., 100 bps per year for an eight-year hold; 50 bps annually for a 16-year hold, etc.). Today, front-end loads are typically more like 5%, and annual asset charges are replacing front-end loads for today’s retail investors. Moreover, some individuals are do it yourself investors and incur little if any of this cost. Bogle uses a blended figure of 0.5% for this cost.
In total, Bogle estimates the advantage of index funds over actively managed funds at 2.21% on an all-in basis (2.27% for actively managed funds versus 0.06% for index funds equals a gap of 2.21 percentage points).
The 65% difference
To use these figures in a simple example, assume a stock market return of 7%, and a 2.27% estimated annual cost of an actively managed fund. The costs are almost 33% of the return, whereas 0.06% would represent less than 1% of the return. Bogle then finished his study by assuming an investor age 30 saves for retirement at age 70. This investor, at retirement, would have up to a 65% enhancement in capital by going the index versus the active route. That’s something to think about, for sure.
David West, CFA, FCSI, has more than 30 years’ experience in the financial services industry as an adviser, trainer, writer and commentator. He has written for The MoneyLetter, The Money Reporter, Canadian Business Online, and many other business and finance publications, and is a regular contributor to the Fund Library.
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