A recent paper on the
ongoing active versus
passive investment debate
concludes that the cost to
investors of actively
managed funds is likely to
be significantly greater
than previously thought. The study argues that in
addition to the standard
management fees, one needs to also consider costs derived from turnover
activities, cash drags (typically 5% exposure of the
portfolio) and, in some cases, hefty front loads. Summing up the additional expenses, the annual cost
advantage of a broad index passive investment fund is in
the order of a startling 2.25%. The results are even more
dramatic over the long run due to the effect of
compounding.
To illustrate this, assuming a long-run annual real rate of return of 7% from the stock markets, the average expected annual rate of return of the actively managed fund should be somewhere in the region of 4.75%. Investing $10,000 at this rate for 50 years would produce slightly to the north of $100,000 at the end of the period. This is a shortfall of roughly $192,000 when compared to the stock market return of 7%. Such is the power of compounding. A more suitable comparison would be with a passively managed “index tracker” fund, and the one chosen in the study came with a total expense ratio of 0.06%3. The end result was similar to those involving the stock market.
To be fair, the study makes a lot of assumptions and does not consider that a few actively managed funds do tend to outperform the markets and by a significant margin. The challenge with this is in picking the winners in advance: past performance has been shown to be an extremely poor predictor of future results. So the safest bet for a long-term investor might as well be to stick to index trackers. By doing so will not in itself guarantee superior results over the long run. For that, you would need to also pre-commit yourself to sticking to those exact same investments over the long run.
The problem here is one of behavioral biases. For example, by tracking closely the performance of your investments, you increase the likelihood of making costly mistakes4. This is especially true during times of market turmoil, when emotions tend to run high. What may have began as a buy and hold strategy can end up resembling the works of a day trader. So even if the underlying investments have low total expense ratios, switching in and out of them will invariably jack up the turnover and cash drag related costs.
So how does one go about a problem like this? A possible solution may lie with what is known in economics as the “commitment device”. In a nutshell, it involves locking oneself onto a course of action that might not otherwise be chosen, but that produces a desired effect over the long run.
A trust is structured as a sort of commitment device in the sense that it is managed by a trustee for the good of the beneficiaries. An example would be a beneficiary who happens to be a minor at the time the trust is established. The trust would ensure that the beneficiary would only have access to the fortune upon completion of a specified objective (age, education degree etc). The imposition of such a commitment device would presumably help avoid a situation where the beneficiary inherits the fortune prematurely, and proceeds to spending it recklessly.
For investments, cryogenically freezing the investor could be the perfect commitment device but unfortunately not exactly practical. Although current technologies are perfectly capable of freezing and storing, they are as of yet unable to resurrect. A far less radical method might be to simply shield oneself from all markets related news, but that would require a lot of discipline in an age of connected and ubiquitous information.
Another approach that could work would be to pre- commit a portion of one’s wealth into a binding, long-term contract of investments in a selection of index trackers, with a simple and transparent rule based and computer managed asset allocation overlay. The fact that only a portion of the wealth would be involved and the use of a straightforward, rules based approach would probably ensure a greater degree of compliance.
To illustrate this, assuming a long-run annual real rate of return of 7% from the stock markets, the average expected annual rate of return of the actively managed fund should be somewhere in the region of 4.75%. Investing $10,000 at this rate for 50 years would produce slightly to the north of $100,000 at the end of the period. This is a shortfall of roughly $192,000 when compared to the stock market return of 7%. Such is the power of compounding. A more suitable comparison would be with a passively managed “index tracker” fund, and the one chosen in the study came with a total expense ratio of 0.06%3. The end result was similar to those involving the stock market.
To be fair, the study makes a lot of assumptions and does not consider that a few actively managed funds do tend to outperform the markets and by a significant margin. The challenge with this is in picking the winners in advance: past performance has been shown to be an extremely poor predictor of future results. So the safest bet for a long-term investor might as well be to stick to index trackers. By doing so will not in itself guarantee superior results over the long run. For that, you would need to also pre-commit yourself to sticking to those exact same investments over the long run.
The problem here is one of behavioral biases. For example, by tracking closely the performance of your investments, you increase the likelihood of making costly mistakes4. This is especially true during times of market turmoil, when emotions tend to run high. What may have began as a buy and hold strategy can end up resembling the works of a day trader. So even if the underlying investments have low total expense ratios, switching in and out of them will invariably jack up the turnover and cash drag related costs.
So how does one go about a problem like this? A possible solution may lie with what is known in economics as the “commitment device”. In a nutshell, it involves locking oneself onto a course of action that might not otherwise be chosen, but that produces a desired effect over the long run.
A trust is structured as a sort of commitment device in the sense that it is managed by a trustee for the good of the beneficiaries. An example would be a beneficiary who happens to be a minor at the time the trust is established. The trust would ensure that the beneficiary would only have access to the fortune upon completion of a specified objective (age, education degree etc). The imposition of such a commitment device would presumably help avoid a situation where the beneficiary inherits the fortune prematurely, and proceeds to spending it recklessly.
For investments, cryogenically freezing the investor could be the perfect commitment device but unfortunately not exactly practical. Although current technologies are perfectly capable of freezing and storing, they are as of yet unable to resurrect. A far less radical method might be to simply shield oneself from all markets related news, but that would require a lot of discipline in an age of connected and ubiquitous information.
Another approach that could work would be to pre- commit a portion of one’s wealth into a binding, long-term contract of investments in a selection of index trackers, with a simple and transparent rule based and computer managed asset allocation overlay. The fact that only a portion of the wealth would be involved and the use of a straightforward, rules based approach would probably ensure a greater degree of compliance.
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