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Estimating the Cost of Lagging the Market

I was asked recently if I could come up with a single number that would illuminate the cost of active management. After thinking about it for a while, I think I have it, and I thought I'd share it with you this week.

Nearly 2,600 general equity funds have been in existence for the past decade. (I'm forced to ignore the hundreds of funds that were merged or liquidated along the way. Approximately five percent of all general equity funds -- inevitably the poorer performers -- are put out of their misery every year.) Of those survivors, 52 percent have lagged the 4.6 percent average annual return provided by the Total Stock Market index, earning an average annual return of 2.6 percent.

Those laggards have charged an average expense ratio of 1.4 percent during that period, and their investors have forked over an estimated $88 billion of fees during the decade.

That's a lot of cash spent for the privilege of lagging the market by a cumulative 27 percent over ten years. But that's not the end of it.

I conservatively estimated that the investors in these funds paid total sales loads of another $1 billion, bringing the cost to $89 billion.

But now for the real kicker: the opportunity cost.

If rather than lagging the market by 2 percentage points annually the assets in those funds had earned the market return, they would be worth $143 billion more than they are today.

Total those figures up, and the true cost of lagging the market for the investors in those funds comes to $232 billion over the past decade. And if anything, this is a conservative estimate of the cost of lagging the market. As I mentioned, I've ignored the cost incurred by those investors whose funds died along the way, which could easily push the total to some $250 billion. (And of course, even that amount excludes the cost borne by investors in the thousands of funds that don't have a ten-year record, which are not included in this analysis.)

I'm not an economist, but I think it's safe to say that the retirements of this contingent of investors would be a lot more secure if their share of that total was in their pockets, rather than residing with their mutual fund managers (who siphoned off their outsized fee rewards) and the hedge fund managers, corporate insiders, and other investors who divvied up the opportunity cost incurred by the fund investors.

$250 billion over a decade. It's a number you might want to keep in mind the next time you find yourself tempted to dip a toe into the actively managed fund waters.

You should follow me on Twitter here.
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