Why Active Management is Eating Up Your Nest Egg

People hand over their nest egg to active managers who claim they can pick stocks, time the market, and make tactical asset allocations. Many times the managers do OK for a period, and historical results seem to indicate superior performance. But careful analysis of long-term results show that very few active managers outperform the market after all fees are taken into account. Furthermore, it has been shown that outstanding performance doesn't persist; and it is not possible to pick the managers who will outperform the market.

Why is this? After all, these are the brightest of the brightest. They consume considerable resources in their endeavors. One important reason is as follows. Investing is a zero sum game. When a stock transaction takes place, there will be a winner and a loser. In the aggregate, professionals make up about 90% of the market. In other words, they are the market. The key to understanding long-term under performance is to understand fees. Here is a table taken from "The Intelligent Asset Allocator" by William Bernstein, page 92. Click to enlarge. Understanding this table can save your retirement dreams.



Look at Large Cap. If you get buy an actively managed fund that seeks to outperform the S&P 500 there is an expense ratio,on average, right off the top, of 1.30%. Also,these funds typically have high turnover - in other words they trade a lot. This takes another 0.3%. This is a fee you don't see. There is a bid-ask spread that takes another 0.3%. Note this is considerably larger for less liquid parts of the market like small cap etc.

The bottom line is that professional managers on average make close to market returns but fees subtract so much that the bottom line is greatly impacted.

The good news is that today (this hasn't always been true-it's a fairly recent developement) it is easy to achieve close to market returns after all fees by buying low-cost, indexed, ETFs. For example, the SPY, which tracks the S&P 500, has an expense ratio of .09%. By buying this the individual investor saves 2.1% of assets right off the top EVERY SINGLE YEAR.

Disclosure: This material is for educational purposes and is not intended as specific investment recommendation. Individual should consuly an advisor and do their own research before investing. The writer holds SPY.