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An Easy Two Percent

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

If you could be highly confident that you could improve your investment returns by almost 2% per year while taking less risk, would you do it?

Does it sound too good to be true? Does it sound like a con job? Well, it’s not.

Victims of active managers endure average net returns of about 2% below the appropriate index in every market or market segment in the world. They can be highly confident that active managers will fall short by about that amount. The odds are from 70 to 80 percent that active managers will fall short of the index during any particular time frame while generating additional risk and enormous tax bills in a futile attempt to beat the index.

Active managers somehow convince investors to pay them fees against all the available evidence that they can add value. In mutual funds, these fees and some other expenses are disclosed in the fund’s prospectus as expense ratios.

Other expenses often exceed the disclosed fees. Any purchase or sale of a stock by the fund will generate a commission to the broker. In addition, there is a bid-ask spread on every security transaction. The market maker buys at one price and sells at a higher price. Finally, a fund or manager can impact the price of the stock by purchasing or selling shares in excess of the market demand. Unloading a big position can take a long time and drive the price of a stock down in the process.

These other expenses every bit as real as the expense ratios, but not properly disclosed. They can only be imputed from a fund’s turnover ratio. For accounting purposes, these costs are included in the stock prices that the fund obtains on purchase or sale, reducing net performance. Higher turnover leads to increased costs and reduced performance. There is a strong direct relationship between fund turnover and underperformance.

It shouldn’t surprise you that for investors as a whole, average performance is reduced almost exactly by average costs. Mathematically, this must be the result.

While returns fall, risk rises because the dispersion around the average result is large. For instance, a particular fund might fall 10% or more below the average. Clearly that would be a disastrous result. And this risk is entirely uncompensated. For bearing the risk our expected return falls 2%!

Of course, a few funds or managers always beat the index. That’s what keeps the suckers coming back. But, your chance of picking those funds or managers in advance is only 20% to 30%, and past performance is a proven thoroughly useless guide and brain-dead strategy. If past performance was a useful strategy, we could all use last year’s Morningstar results and end up rich.

Index funds have negligible turnover and rock bottom expense ratios. So, switching from an active to passive strategy increases your expected return by almost 2%! And passive strategies slash your tax obligations on gains in the process.

Bottom line here, you have to have a compelling reason to reject index funds as the only rational investment choice. Do the right thing: Index. It’s the easiest 2% you will ever earn.

If you could be highly confident that you could improve your investment returns by almost 2% per year while taking less risk, would you do it?

Does it sound too good to be true? Does it sound like a con job? Well, it’s not.

Victims of active managers endure average net returns of about 2% below the appropriate index in every market or market segment in the world. They can be highly confident that active managers will fall short by about that amount. The odds are from 70 to 80 percent that active managers will fall short of the index during any particular time frame while generating additional risk and enormous tax bills in a futile attempt to beat the index.

Active managers somehow convince investors to pay them fees against all the available evidence that they can add value. In mutual funds, these fees and some other expenses are disclosed in the fund’s prospectus as expense ratios.

Other expenses often exceed the disclosed fees. Any purchase or sale of a stock by the fund will generate a commission to the broker. In addition, there is a bid-ask spread on every security transaction. The market maker buys at one price and sells at a higher price. Finally, a fund or manager can impact the price of the stock by purchasing or selling shares in excess of the market demand. Unloading a big position can take a long time and drive the price of a stock down in the process.

These other expenses every bit as real as the expense ratios, but not properly disclosed. They can only be imputed from a fund’s turnover ratio. For accounting purposes, these costs are included in the stock prices that the fund obtains on purchase or sale, reducing net performance. Higher turnover leads to increased costs and reduced performance. There is a strong direct relationship between fund turnover and underperformance.

It shouldn’t surprise you that for investors as a whole, average performance is reduced almost exactly by average costs. Mathematically, this must be the result.

While returns fall, risk rises because the dispersion around the average result is large. For instance, a particular fund might fall 10% or more below the average. Clearly that would be a disastrous result. And this risk is entirely uncompensated. For bearing the risk our expected return falls 2%!

Of course, a few funds or managers always beat the index. That’s what keeps the suckers coming back. But, your chance of picking those funds or managers in advance is only 20% to 30%, and past performance is a proven thoroughly useless guide and brain-dead strategy. If past performance was a useful strategy, we could all use last year’s Morningstar results and end up rich.

Index funds have negligible turnover and rock bottom expense ratios. So, switching from an active to passive strategy increases your expected return by almost 2%! And passive strategies slash your tax obligations on gains in the process.

Bottom line here, you have to have a compelling reason to reject index funds as the only rational investment choice. Do the right thing: Index. It’s the easiest 2% you will ever earn.