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:
- As a Rational Investor you realise you can’t outperform the markets, neither do you know someone who can.
- 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 .
- Think about your other assets in a portfolio context.
- Think hard about your risk levels.
- Be clever about tax.
- 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.
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.
|Up-front fee||2.00%2 ||0.00%|
|Other expenses3 ||0.20%||0.15%|
|Bid/offer ||0.35%||0.25%4 |
|Transaction tax||0.25%||0.00%6 |
|Total per trade||1.00%||0.60%|
|Total trading costs||1.25%||0.06%|
|Annual cost||2.45%7 ||0.41%|
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%|
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.
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.
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.
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.
- For UK investors, these would be UK government bonds, a.k.a. gilts. [↩ ]
- Do Not Pay This! [↩ ]
- Audit, legal, custody, directors, etc [↩ ]
- Rebalance at times of liquidity [↩ ]
- Trackers don’t pay for research etc [↩ ]
- ETFs can typically avoid stamp duty etc [↩ ]
- Or 4.45% if you pay an up-front fee. [↩ ]
- Some active funds even have exit fees, but those are increasingly rare. [↩ ]