How Costs Destroy Your Returns

William Sharpe once demonstrated why, when grouped together, active managers must underperform passive managers. The simple explanation is that the incremental costs of active management create an insurmountable hurdle. Now, there's similar evidence showing that active funds may lag passive funds even when they appear to show outperformance.

There's an overwhelming body of evidence demonstrating that efforts to generate alpha are highly unlikely to prove productive after costs, such as fund operating expenses, trading costs, incentive fees and taxes. (My next book, The Quest for Alpha, due out in February, presents a summary of the evidence on the efforts to generate alpha.)

The bottom line is that the evidence for the active management faithful is downright ugly, but truthfully, all you have to do is look at costs.

Mark Kritzman of Windham Capital Management provided the following hypothetical breakdown of the before and after returns of an index fund, a mutual fund and a hedge fund. Here are the assumptions:

• Your tax burden is similar to that of Massachusetts.
• You're in the 35 percent federal tax bracket.
• Your investment options and relevant assumptions are broken down in the following table, with each asset investing in the same asset class without leverage.

The analysis by Kritzman demonstrates both how high a hurdle actively managed funds have and why there's so little evidence of persistent outperformance. It also shows the wisdom of John Bogle who stated: "The realistic epitome of investment success is to realize the highest possible portion of the market returns earned in the financial asset class in which you invest-the stock market, the bond market, or the money market-recognizing and accepting that that portion will be less than 100 percent."

As Kritzman observed: "It is very hard, if not impossible, to justify active management if your goal is to grow wealth. If, instead, you view active management as a source of entertainment, you may wish to consider less costly ways to amuse yourself." My own advice is that if you need the stock market to provide entertainment, it's time to get another life.

More on MoneyWatch:
The Costs of Active Management Why a High-Dividend Stock Strategy Isn't a Good Approach Hedge Fund Update for November Have You Been Misled by Returns Information? The Smartest Things Ever Said About Market Forecasting
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