The Costs of Active Management

(MoneyWatch)  When William Sharpe wrote his paper "The Arithmetic of Active Management," he demonstrated that active investors must earn the same rate of return as passive investors in aggregate. The difference was that the costs of active management would cause active investors to underperform passive investors as a whole. But how much does active management cost? Would you believe about $80 billion per year?

Professor Kenneth French studied this in his 2008 study "The Cost of Active Investing." French compared the costs of investing in U.S. stocks (fees, expenses and trading costs) with an estimate of costs if everyone invested passively. The difference is the cost of active management. Here's what he found:

• The value-weighted cost of all mutual funds (active and passive) fell from 2.08 percent of assets under management in 1980 to 0.95 percent in 2006. The decline is mostly explained by passive funds (including ETFs) increasing share from 1 percent to more than 12 percent.
• As you would expect, institutional costs are dramatically lower. The value-weighted costs for institutions fell from 0.34 percent in 1980 to 0.23 percent in 2006. Institutional costs declined for two reasons. First, the costs they pay for active and passive investments declined. Second, institutions shifted a large portion of their U.S. equity holdings from active to passive.
• The average annual hedge fund fee was 4.26 percent of assets. The average for investors who buy through funds of hedge funds is 6.52 percent because they pay two layers of fees.

French estimated that the total cost of investing in 2006 was 0.75 percent of the value of all NYSE, Amex and NASDAQ stocks. This includes the fees and expenses paid for mutual funds, the investment management costs paid by institutions, the fees paid to hedge funds and funds of funds and the transaction costs paid by all traders.

He also estimated that if all investors paid passive fees and there were no hedge funds, the cost of investing would have been just 0.09 percent. The difference between the actual and passive estimates measures the cost of active investing. Based on a market capitalization of about $12 trillion, active investors transfer about $80 billion annually from their own wallets to the purveyors of actively managed products and market makers.

It's important to note that despite the enormity of the costs, French's estimate may be too low. It doesn't account for the incremental burden of higher taxes incurred by active investors with taxable holdings.

French made the important observation that the cost of active investing is not a pure loss to society -- the price discovery activities of active managers improves the accuracy of financial prices and allows for an efficient allocation of capital. The good news for passive investors is that you get to be "free riders," benefiting from the activities of active managers without paying the costs.