There is an inverse relationship between fund expenses and returns. In short, costs matter. Nobel Laureate Dr. William Sharpe points to this in his landmark article, “The Arithmetic of Active Management,” in which he asserts simply:
“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.”
Hard to argue with the facts. Though it is extremely difficult to overcome the high cost hurdle of active management and attempting to time the market, many managers and investors go down trying. Their constant pursuit of “alpha,” the risk-adjusted measure of return above an appropriate benchmark, more often than not brings about complexity, stress, and a lighter wallet. Significant, consistent alpha is required for an active manager to match the performance of an appropriate indexed or passive strategy due to the additional costs borne. The figure below tells a powerful story.
In addition to high internal expenses on actively-managed funds, other costs inherent in such strategies create further headwinds. “Wrap” accounts commonly charge 1-3% of assets under management. 12b-1 fees serve to offset marketing costs in many actively managed funds, increasing costs to investors. Transaction costs can also be significant, due to high turnover attributable to market timing and security selection, leading to tax inefficiency and, potentially, a bigger bill from Uncle Sam.
Once all costs, taxes, expenses and commissions are compiled, total costs not only negate most gains made by pursuing alpha but often result in returns that significantly lag market indices. Remember, a penny saved is a penny earned. Stay diversified.
Foster Group Inc. is a fee-only investment adviser firm providing a holistic approach to wealth management and financial planning, as well as traditional investment and portfolio management offerings. The firm has more than $1.4 billion in assets under management and services more than 950 clients across 38 states, with a specialization for clients in the medical profession. For more information please visit www.fostergrp.com/IMS or call 1-844-437-1103.
The information and material provided in this article is for informational purposes and is intended to be educational in nature. We recommend that individuals consult with a professional advisor familiar with their particular situation for advice concerning specific investment, accounting, tax, and legal matters before taking any action.