The Bookie’s Cut

When choosing an investment strategy, there’s probably nothing more important than focusing on the fees.

We talked about diversification, and how it is the only “free lunch” in investing.

We discussed rebalancing and how it allows you to repeatedly buy low and sell high.

These aspects of asset allocation and investment behavior are incredibly important.

But they’re probably not as important as investing in low-cost index funds to the exclusion of expensive ones.

You will remember that in passive aggression, we discussed how active managers have a roughly 2/3 probability of underperforming the low-cost passive funds which track the indices . In addition, if an investor were lucky enough to invest in one of the one third of active funds which outperformed its respective indices, the investor would not be paid commensurate with the risk he was taking (of underperformance. )

But why is that?

Think of it this way ; Imagine a stock market or index. There are only two forms of investors involved with this market ; active investors and passive investors.

Passive investors simply track the index. If the entire index goes up, their investment goes up. If any one position within the entire market goes up relative to other positions, that positions weight is equivalently adjusted within the passive fund. If the entire market goes down, the index fund goes down with it. Thus passive investors have (almost) no effect on the value or direction of either the total index or the individual holdings within it.

The active investors on the other hand are weighting  their investments based on their understanding of perceived inefficiencies within the market. They are betting on individual stocks that they think will outperform the competition. And sometimes they’re betting against stocks that they think will underperform the competition.

But if they’re right, then someone else is wrong. A dollar gained by one investor must be a dollar lost by another investor. And since the passive investors are neither losing nor gaining money relative to the index, The only people who are losing excess money are other active investors.  It is a zero sum game.

But that’s not the only factor. The other important issue is that active investing is more expensive. Each trade costs money. And that money comes away from the investment’s gains and dividends. And it is subtracted from the fund even when the fund loses value.

Placing active bets is also tax inefficient, placing the investors at risk of having to pay short and long-term capital gains taxes for their winnings. More money which is taken from the investors’ pockets.

Finally the frequent trading increases the volatility (read : risk) and this decreases the annualized return for active funds relative to index funds. (see free lunch)

Because of these inefficiencies, the average active equity fund has an expense ratio of about 1.2 %. The average passively managed index fund has an expense ratio of about 0.2%.

So how much does this one percent difference matter?

An awful lot.

First imagine that a fund has a 5% return per year over time. A 1% decrease in this return represents a relative loss of 20% of the gains per year. But consider also that this loss of 1% happens right now, in today’s dollars. So if the investment is returning 5% per year over time, and Inflation is at 2%. It’s really only gaining 3% per year of real returns. And 33% of this real return is lost to expenses!

Finally, the money that is lost to expenses, never compounds upon itself. So a small sum deducted becomes a large sum lost over time.

So let’s look at the effect of 1% additional expenses on a portfolio over 40 years. This is taken from an excellent Vanguard essay which I urge you to read.

http://vanguardblog.com/2011/10/28/stopping-the-silent-killer-of-returns/

1% lost to expenses means;

A loss of 18% of the total portfolio value at 20 years.

A loss of 25.7% of the portfolio value at 30 years.

A loss of 32.8% of the portfolio value at 40 years.

So overlooking that 1% now is like giving a 33% pay cut to the future You, 40 years from now.

How would you like 33% of your current salary to be reduced?

(Future You wanted  me to ask you that question. )