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The cost of active fund management

Photo of Lars Kroijer hedge fund manager turned passive index investing author

I am delighted to welcome a new occasional contributor to Monevator! Lars Kroijer was a successful hedge fund manager but he now advocates passive index investing as the best approach for most people. You can read more from Lars in his book, Investing Demystified.

The vast majority of people have no edge over others in the stock market. Even professional fund managers who have demonstrated skill in picking stocks in the past struggle to beat the market once their high costs are taken into account.

This may sound like a counsel of despair, but it’s just a call to accept reality. You don’t need to beat the market to invest successfully in shares and other assets. But you do need to try to get the average return from the different asset classes as cheaply and effectively as possible.

I have a term for those wise people who have accepted this – I call them Rational Investors.

The way of the Rational Investor

In my book Investing Demystified I explain how to be a Rational Investor:

  1. As a Rational Investor you realise you can’t outperform the markets, neither do you know someone who can.
  2. The Rational Portfolio therefore consists of funds that track broad indices of equities as well as risky government and corporate bonds, and an allocation of “minimal risk bonds”1.
  3. Think about your other assets in a portfolio context.
  4. Think hard about your risk levels.
  5. Be clever about tax.
  6. Implement the portfolio as cheaply as possible.

Keeping costs low is vital to being a Rational Investor. Since you are not going to try to outperform the market, it makes no sense to pay a penny more than you have to in order to achieve as close to the market’s return as you can.

Ironically, this will be your edge over those non-Rational Investors who are striving to do better.

By keeping costs low, you can end up richer than those who pay a high price to try to beat the market and fail.

Active management comes at a cost

There are too few people from the world of finance who are interested in emphasising the importance of low fees to investors.

Perhaps that’s not surprising – they are after all the ones making money from those same fees.

Fees are always important in finance, but even more so for the Rational Investor. Since we don’t think we’ll be able to outperform the market, we’re not asking anyone to be particularly clever about investing. We just want someone to replicate the market.

As a result we should expect to pay very little for it.

Why index fund investing works

Inertia is a powerful force. It either makes us leave our investments where they are or makes us buy the well-known active funds like so many others.

Many people are aware of the extra costs of these active funds, but often they don’t seem to act on it. Instead, they accept the status quo – please don’t let that be you.

It seems paradoxical that people spend countless hours comparing the price of computers or holidays, when the same time spent researching better and cheaper financial products would far outweigh the cost savings they make elsewhere.

The price of active management

The following table compares the cost of investing in a passive index-tracking product with investing in a typical active fund tracking the same index.

Active Tracker
Up-front fee 2.00%2 0.00%
Annual
Management fee 1.00% 0.20%
Other expenses3 0.20% 0.15%
Trading costs:
Bid/offer 0.35% 0.25%4
Commission 0.15% 0.10%5
Price impact 0.25% 0.25%
Transaction tax 0.25% 0.00%6
Total per trade 1.00% 0.60%
Turnover 1.25x 0.1x
Total trading costs 1.25% 0.06%
Additional taxes 0.00%  (*) 0.00%
 —-  —-
Annual cost 2.45%7 0.41%

*Additional taxes may be payable with some even more active strategies.

Paying initial fees just to get into an active fund – the up-front fee of 2% in my table above – is becoming a thing of the past8, but you can see from this example how you might still save another 2% a year by investing in an index tracking fund, compared to an active one.

If a 2% annual saving does not seem like a lot to you, then you’re forgetting the power of compounding returns.

Let’s assume that you’re a frugal investor who diligently puts aside 10% of their £50,000 income from the age of 25 to 67 (we’ll assume your income will go up with inflation, and to simplify our example we’ll also assume that this is an average over a lifetime – obviously few 25-year olds make £50,000!)

Let’s say you aggressively put all your savings into equities (this is just for illustration – in virtually all cases you should have a good portion of your savings in lower risk assets like government bonds).

How much of a difference would you expect your decision to invest in an index tracking product as opposed to an active fund to make?

For this example we’ll assume the following nominal cumulative returns before fees (and we’ll ignore taxes for now):

Minimal risk rate 0.5%
Equity risk premium 4.5%
Annual inflation 2.0%
——
Total 7.0%

 

So, we’re going to model for 7% returns from this investing plan. Where does this leave you in our example?

Well, as you get ready to retire at age 67 after 42 years of diligent index tracking, the difference in your savings pot is staggering compared to somebody who invested in active funds. All told you are better off by £643,000 by investing with an index fund as opposed to with an active manager.

Index-fund-active-fund-comparison

Adjusting the £643,000 for inflation, that extra amount is still around £280,000 in today’s money.

  • If you took the active route and managed to avoid paying the up-front charges, your active fund investment would have been higher by about £23,000 at age 67. That demonstrates the advantage of at least avoiding the initial charge.
  •  If you had avoided the up-front charge AND if there had only been a 1.5% annual difference in costs, then the difference in savings at retirement would still amount to £494,000.

If you think you have great edge in the market and you could easily make up this 1.5% to 2% annual cost difference by picking stocks or choosing superior active fund managers or timing the markets or whatever other approach you take, then good luck to you. All the odds and evidence are against you.

If you don’t have an edge, then the sooner you get out of the expensive investment approaches and into cheap index tracking products, the better off you will be.

(I’ll discuss exactly which index you should track in a later article).

Note: Shouldn’t I expect an active fund to make higher returns? In a word, no, you should not expect your active manager to outperform the index before fees. Obviously some managers will do so, but in aggregate the active managers together perform in line with the index before fees. It is because of their significant trading and management costs and other fees that active funds under-perform so starkly compared to index tracking products.

How to get an active manager’s sports car

By not giving money to an active manager (who probably was not able to outperform anyway) you saved £280,000 in today’s money in our example.

Just imagine the difference in quality of life that kind of money would make in retirement, or for your relatives after you are gone.

Conversely, consider the 85-90% of investors who invest in active managers as opposed to index tracking funds, either directly or via their pension funds. (Index tracking may be popular among Monevator readers, but it’s still a minority sport in the wider world!)

Over the long run only a very small percentage of investors who take the active approach will be lucky enough to invest with managers that give better returns after fees.

The rest have simply paid a staggering amount of money to the financial industry over their investment lives, and will have less money in retirement as a result.

To put things into perspective, the next time you see a finance person driving a Porsche or jetting off to a holiday home in Spain,  consider that the additional and unnecessary active management fees paid by just one individual saver – added up over their investing lives – could buy seven to eight Porsches! And that paradoxically this is money paid to the finance industry by a saver who typically could not afford to drive a Porsche themselves.

If you know all this and are still happy paying high fees, then at least stop complaining about people in finance making too much money and driving fancy cars.

Note: What about picking your own stocks? You are not forced to choose between an active manager or index tracker. As many people do, you could manage your own portfolio with your own individual stock selections. This decision goes back to the question of having edge in the first place. If you don’t have edge – and the vast majority don’t – then this “do it yourself” approach is a loser’s game for you, as you will not be able to pick a superior portfolio to that of the market. Buying the market via index trackers will be far less hassle and much more cost effective. (If you do have edge, then I look forward to reading about you in the Financial Times.)

Passive investing requires patience

Focussing on fees when we seek investment success does not deliver instant gratification. As index investors there is no stock that doubles in a month. To really notice the additional profit we gain from being clever about expenses takes years or even decades.

The key to reaping the greatest savings is to have the patience for the compounding impact of the lower expenses to take effect. It is like making money while you sleep; lower fees make a little bit of money, all the time.

Consider the following chart that illustrates the aggregate savings from the two investing approaches we just examined.

Passive Funds versus active funds

In the early years you can barely see the difference between the active and index tracking investment approaches.

In the later years the benefits are obvious – but they are only there for the investor who kept his or her discipline with lower fees.

Ignore the siren songs of sexy managers

Once you understand the power of compound interest and how it adds up over several decades, then saving 2% or more a year in fees will sound like a much bigger deal.

But even then, you must remember it will take discipline to stick to this approach.

After all, 2% sounds a lot to you now when reading this article, but will you really notice the 2% you saved amid the noise of the investment markets?

In any given year – probably not.

The index tracker will perform slightly better over the long-term than the average active fund, and that outperformance will come from the cumulative advantage of lower fees.

Meanwhile the performance of the many active funds out there will be all over the map. Along the way the best performers will try to scream the loudest about how their special angle or edge has ensured their amazing returns that year.

Investing Demystified book coverWe might even be tempted to believe these managers and abandon our boring and average index tracking strategy.

But please stick to your index investing plans unless you can clearly explain to yourself why you have edge.

The chances are you don’t, and you will be wealthier in the long run from acknowledging this.

Lars Kroijer’s Investing Demystified is available now from Amazon. Lars is donating all his profits from his book to medical research. Check it out now.

  1. For UK investors, these would be UK government bonds, a.k.a. gilts. []
  2. Do Not Pay This! []
  3. Audit, legal, custody, directors, etc []
  4. Rebalance at times of liquidity []
  5. Trackers don’t pay for research etc []
  6. ETFs can typically avoid stamp duty etc []
  7. Or 4.45% if you pay an up-front fee. []
  8. Some active funds even have exit fees, but those are increasingly rare. []

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{ 26 comments… add one }
  • 1 Julian Brennan February 13, 2014, 4:15 pm

    All nice and good. I assume that most readers of this blog already know that low cost investing is the key to financial success. Financial retards who still buy the load and active management funds are not reading this. Why these repetitive pitches?

    Also what I don’t understand is the permanent bashing of selfies. Who says that the only goal of selecting my own stocks is to beat the market? Selecting my own stocks over a passive index fund rather gives me a more individualized approach on risk & return expectations. The expenses are so much lower than tracking an index fund: buy stock once (usually with a 1% commission or less, depending on the amount invested) and never pay a fee again. Beat that!

  • 2 Jon February 13, 2014, 5:57 pm

    Kinda agree with Julian. Cost of Index Funds versus HYP maybe a good future subject. After I have selected a share for my HYP (target is 30 diversified UK shares) I never intend to sell them. Either the company goes bankrupt or most likely acquisition/merger. This is even lower cost than an index fund.

  • 3 ermine February 13, 2014, 6:07 pm

    After reading this I am drawn to reread Robert Kirby’s Coffee Can Portfolio – strapline you can make more money being passively active than actively passive.

    Obviously he is part of The Enemy like your good self in a former life, and one of the easy wins with index funds is diversification is easily and cheaply had right off the bat. I’ve got a lot of regard for Jon and Julian’s POV…

  • 4 Andrew Williams February 13, 2014, 6:22 pm

    @Julian It’s only repetitive if you’ve been reading here for a while. For all we know, there is a steady stream of new readers and for some of them, this will be the first article they read. I don’t think that I’d call those people who don’t know this stuff, “financial retards”. There are all sorts of reasons for a person not to know this stuff.

  • 5 The Investor February 13, 2014, 6:33 pm

    On the subject of stock picking, sure you might win on costs but I’m pretty sure Lars would say you’re claiming edge in your stock picks. The stats suggest most stock pickers are not Warren Buffett, even if they aspire to buy Coke and American Express and hold for 30 years. Au contraire, they do worse than average. So what you gain on costs you’d lose on lagging the market.

    Of course I for my sins pick stocks with most of my money, for a variety of reasons, so not having a dig at you guys. And I definitely think some ways are more likely to compete with a tracker for more people than others, of which the long-term buy-and-hold ‘quality’ share HYP approach income is perhaps the best approach.

    On the subject of readers, every day 50-70% of readers on the site are new! That’s a pretty normal sort of stat for all but very small niche sites, by the way.

    So that’s several thousand new people a day. Obviously most don’t stick around, otherwise we’d be the size of the Mail Online by now. And the majority are reading archived articles, not the new ones.

    Subscribers, especially those who have signed up via email, are another matter. They have all seen the site before and they should all get a heads-up on what’s new. The issue there is as Andrew says how long they’ve been around for, as to how familiar this stuff will be.

    For some I suspect all too familiar 🙂 Oh well, think of it as a top-up flu jab in that case.

    But for others, different ways to repeat the message are no bad thing IMHO.

  • 6 BeatTheSeasons February 13, 2014, 8:46 pm

    Long time reader but new idea – spend your career doing something unethical and then make even more money off the back of it by writing a book about how bad it all was/is.

  • 7 L February 13, 2014, 9:30 pm

    Not sure what the negative feedback is about (unethical?). I enjoy Lars’ honesty and brevity. Something which is rare in this field. It’s also one of the reasons that I think make this website excellent.

  • 8 ermine February 13, 2014, 10:03 pm

    On a technical point, in note 6 you indicate “ETFs can typically avoid stamp duty etc”. Is this true of a physically replicated ETF, say Vanguard’s VUKE?

    Yes, they’re domiciled in Ireland, but if they buy a load of say GSK then don’t they still get to pay SD on that purchase? Appreciated the churn should be a small proportion of their total holding unless something really horrible happened to GSK, but are you really saying that the turnover of their ETF portfolio is so low that the amount of SD paid is negligible?

  • 9 averagejoe February 13, 2014, 10:58 pm

    After reading this and hearing some reviews and plugs – I am very interested to know what makes this different, and worth reading, over Tim Hale’s book. As from what I’ve hear and read above it sounds very similar.

    What is Lar’s spin on it that makes it different?

  • 10 Pete Copps February 13, 2014, 11:34 pm

    I agree with L, don’t get the critics here.

    Wish I’d read this at 20!

    Also not ever seen the table of costs and fees laid out so clear before, even on this website (which is excellent by the way..)

    Keep it up Lars most of the commenters are a friendly helpful bunch (I have learned a lot from them as well as the articles, though I am more of a listener here most of the time but wanted to say “Welcome”..)

  • 11 Greg February 14, 2014, 12:39 am

    @ermine
    Physical ETFs are subject to stamp duty on their underlying holdings.
    Note that any cap-weighted fund doesn’t have to buy or sell if a component changes price – cap-weighting is buy and hold.
    (In fact, if a holding got battered, they might make more money from securities lending!)

    They do get slightly nobbled when the index components change, though if the vendor has a tracker containing a contiguous grouping then they can do some clever reshuffling without buying and selling.

    I think the ETF arbitrage system handles the discount without adding to costs, or at least direct costs.

    Personally, I think the fuss about synthetics is overblown and they are perfectly fine.

    Here’s a detailed paper about the two:
    https://pressroom.vanguard.com/nonindexed/6.14.2013_Understanding_Synthetic_ETFs.pdf

  • 12 Len February 14, 2014, 11:09 am

    BeatTheSeasons. You must have missed the point about Lars donating all the profits to medical research. Is that sufficient penance for his “unethical” past, as you refer to it. I’ve read his book and IMHO it is far better than Tim Hale’s.

  • 13 The Investor February 14, 2014, 11:43 am

    Indeed. Also I’m afraid it’s rather naive to think you make a lot of money writing a book about passive investing, anyway.

    I’ve had a couple of big name publishers approach me over the years to see if I wanted to publish Monevator: The Book with them, and ran the numbers. Economically speaking, it’d make more sense to get a Saturday job at McDonalds. 🙂

    Might be different if you write the next mega-best-selling tome about Swing Trading The FTSE For Fun and Ferraris!!! of course.

  • 14 BeatTheSeasons February 14, 2014, 12:12 pm

    What a pity the numbers don’t add up, I thought I’d found a short-cut to financial freedom by writing about the inherent evils of my previous industry or profession.

    Sorry for causing offence with the word ‘unethical’ – next time I’ll stick to the approved terminology!

  • 15 Len February 14, 2014, 12:41 pm

    I’m sorry, but I have a minor criticism of our leader. Not about your writing but your timekeeping. Being retired, and with the time to notice these things, I would point out that my previous post was timed at 11.09 am, instead of 10.09 am. Surely your clock hasn’t been an hour out since last October? Goodness me, a financial writer who can’t tell the time! What’s the world coming to? Or, perhaps you’ve taken up passive timekeeping?
    (Tee, hee).

  • 16 Geo February 14, 2014, 12:44 pm

    All very angry for Valentines day, what’s everyone’s beef?

    I think politely ramming the passive mantra again and again is so important as the stats are probably only 5% of investors are passive and most still find it hard to understand the huge complexity of investing – or at least get past the noise. Every day the fund managers RAM down our throats that active is best so there has to be some balance and I’m very glad Monevator is trying to provide it.

    If some doesn’t understand something calling them a retard isn’t very helpful is it really.

    Happy days now please.

  • 17 L February 14, 2014, 2:20 pm

    I don’t Lars ever said that the hedge fund industry was unethical. The industry is full of people who work hard and are devoted to what they do. A number of managers are good at finding an edge and making the most of it. But as Lars’ experience suggests, the incentives of investors make it inherently difficult for long term excess rewards. For some people there are benefits to investing in hedge funds, but quite rightly Lars points out that for most, those benefits will not be realised.

    @TI, are you sure it wouldn’t sell? It has all the makings of a classic. A guy puts in some effort, brings in a partner. It works well. Then we can throw in some minor peril, maybe you and TA fall out over a young sexy wom… ETF brought to market. Then you reconcile your differences and all is good. Just in time for ominous threat on the horizon, the RDR broker fee catastrophe. Perfect for a sequel, “Monevator: Those RDR fee plans don’t price themselves”. Got yourself a series there…

  • 18 Jon @ Money Smart Guides February 14, 2014, 4:09 pm

    I love the line “getting the average return as cheaply as possible”. So many investors ignore the cost of their investments and don’t realize how it affects them in the end. I was explaining to my wife how we are investing her 401K in only large cap funds and balancing out our allocation through other portfolios. She wondered why we weren’t investing more in small cap funds in her 401k. After I explained to her how much they would cost her and how we could find much cheaper small cap investments, she realized how much fees matter.

  • 19 KL February 14, 2014, 9:19 pm

    while I agree with the spirit of the article, I can’t but disagree re stockpicking.

    Stockpicking can be done for targeting specific returns (the market may return more, who knows, so no claims of outperformance) or constructing portfolios to achieve specific goals. Why is this different to choosing between a portfolio with a%, b%, c% allocations vs x%, y% z%. both approaches are pretty similar.

  • 20 Stephen Gauden-Ing April 14, 2014, 6:20 pm

    Interesting article and have read the book as a result, the thing that scares me is only having 2 products. It doesn’t seem to specify any particular funds/ETFs but hints at VUKE and VGOV, (similar advice to Mr Buffet but looks beyond the US).
    Quick question why should/shouldn’t we choose these ETF pairings over a Vanguard lifestrategy fund or if choosing a global ETF for our equities is too international, going for a triumvirate of a Domestic equity ETF, a global ex UK equity ETF, and a govt bond ETF. Or the monevator portfolio listed elsewhere on the site.
    Given HLs £45 cap on ISA fees for stocks (ETFs) v uncapped 0.45% for funds I’m looking for other pro/cons for moving my money out of the life strategy funds, and isn’t only 2 ETFs a bit too simple. (My fees jumped from £2pm to £12pm under HLs new structure). I’m also reluctant to jump ship whilst there is still blood on the streets post RDR.
    Lastly as a ex UK resident, would there be any other suggestions to IGLO (which sounds like a skin and not a financial product).

  • 21 Lyle McClure May 2, 2014, 6:45 am

    @Stephen Gauden-Ing writes that he has read the book and comments, “the thing that scares me is only having 2 products. It doesn’t seem to specify any particular funds/ETFs but hints at VUKE and VGOV”.

    Chap. 14 of the book, p. 185-201, does a lot more than “hint”, it goes into specific details of various products which can be used to implement the “rational portfolio”.

  • 22 JJ May 30, 2014, 4:11 pm

    Question about this.

    If the benefits are greater the longer you have a tracker would it therefore not be a suitable investment for someone older ie 50+? Say you only have 10 or so years to retire and decide to switch from an active fund to a passive one, would it be worth it?

  • 23 Mark November 14, 2015, 10:35 pm

    Pity there were no replies to the last post, it’s a dilemma I’m in at the moment.

  • 24 The Investor November 23, 2015, 10:55 am

    @JJ @Mark — You’re conflating asset classes (say shares) with vehicles (tracker funds versus active funds).

    Risk/investment time horizon is an issue for shares, however you hold them, not particular for trackers. As you get older you’d typically want to ‘de-risk’ your portfolio by holding more bonds/cash as a percentage of your assets. (So one rule of thumb is your age in bonds/cash, say at 50 you’d be 50% shares, 50% bonds. But this is just one approach, there are dozens of articles on this site on the pros cons).

    Many people use trackers into retirement, but some prefer to target income producing funds directly, at the potential expense of slightly lower returns for potentially more stable income/less faff.

    See our writer “The Greybeard” in these:

    http://monevator.com/tag/deaccumulation/

  • 25 Geri Portillo June 29, 2016, 2:55 am

    Timely ideas , I was fascinated by the specifics – Does someone know if I could acquire a sample IRS 5329 form to fill out ?

  • 26 BlackSamurai摩天楼 January 9, 2017, 3:27 pm

    I am 26 year old that sort of salary haha – just a slight anomaly on that one. Good article 🙂 love this site so much 😀

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