The Price of Active Management
Note: The following is a guest post from Money Smart Guides. His site is a great resource that will help you understand investing and develop your own approach. I know I’ve been neglecting the investing side since I’ve been so focused on paying off my debt, but we definitely have to consider investing as well to make real progress. I have some questions myself which I will be asking in the comments section. Let Money Smart know your questions!
I am a passive investor. This means I buy low cost mutual funds and hold them. I don’t sell when the market drops and buy when the market rises. Actually, that isn’t entirely true. I am always buying, so I do buy high. But I don’t sell unless my portfolio needs rebalancing. I have a long-term time horizon and have the mentality that I will invest and not worry about the day to day fluctuations of the market.
To me, investing is like driving. I could get mad every time a person cuts me off to get to the off ramp, or tailgates me while flashing his lights. Sometimes I do get mad. But overall, I am only concerned with getting to where I want to go. I try my best to ignore the short-term distractions and look at the long-term. The same holds true with investing. I sometimes get caught up in the media hoopla, but overall, I am focused on the long term.
Why do I choose to pick passively managed funds? The main reason is because the majority of the time (roughly 80%) active managed funds do not beat the market. One of the underlying reasons is because of the fees they charge.
The average domestic actively managed mutual fund charges 1.46% in fees. Compare that to the average domestic passive mutual fund which charges 0.18%. You may be asking what the significance of 1.24% is. Since we all love math, let’s look at an example.
You have two mutual funds. Fund A has an expense ratio of 0.18% while Fund B has an expense ratio of 1.46%. $10,000 is invested in both funds for 10 years. Both funds return 5% annually. In 10 years, Fund A is worth roughly $16,000 while Fund B is worth about $14,000. Why the difference? The fees!
By investing in Fund A, you paid $215 in fees in those 10 years. With Fund B, you paid $1,800 in fees. You cost yourself over $1,500.
If we expand the example to a return of 8% annually over 30 years, what happens? Fund A is worth over $95,000 and Fund B is worth just under $65,000. In Fund A, you paid about $2,100 in fees and in Fund B you paid close to $13,500 in fees.
So not only did you pay more fees by investing in Fund B, but the higher fees forced you to earn a lower return. By paying more in fees, your compounded returns are less each year compared to a fund with lower fees. This results in lower returns as there is less money that compounds upon itself. (Read here for a refresher on compound interest.)
The story is worse when you look at international funds. Average expense ratios for passive funds is 0.33% while they are 1.64% for active funds.
Some readers may argue that two funds will not return the same percent each year for 10 years. I agree with this. But sadly, as I mentioned above, 80% of active managed funds DO NOT BEAT THE MARKET. I was being generous comparing two funds with the same return. In reality, the active managed fund will have a lower return over the course of the time period making it even more evident that passive investing is the way to go.
I know you want to get rich quick. Everyone does. Many people think that by beating the market they will get there quicker. They won’t. Most times actively managed funds don’t beat the market. Combine that with the opportunity cost of lower returns from higher fees, it’s a wonder why anyone invests in these funds. Save yourself time, money and energy. Invest in passive mutual funds and enjoy the ride. After all, fees are one of the few things you can control when investing in the stock market.