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Gary Karz, CFA (email)
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Principal, Proficient Investment Management, LLC and


     The January 2010 issue of Consumer Reports had an interesting survey about complaints. 1125 Americans were asked to score 21 gripes on a 1-to-10 scale, 1 meaning an experience "does not annoy you at all" and 10 meaning it "annoys you tremendously." Hidden fees scored 8.9 overall. It was the most annoying gripe in survey.

     Direct mutual fund expenses have generally been well publicized, studied, and analyzed by academics and the press. But recently other investment costs have started to draw more attention in the press and academic community. There are many costs that investors may incur depending on their investment vehicles, specific securities, and various advisory services. Some are transparent and well known, but many are more difficult to determine and/or are frequently ignored. Both individual do-it-yourself investors, as well as investors using one or more services face many of these costs.

     Investment costs that investors may incur include

     Investors in Retirement Accounts (IRAs, 401(ks), etc.) generally face 1) Management and administrative costs as well as 2) Mutual fund expenses. Investors using Investment Advisers/Financial Planners generally face either asset based fees or hourly fees (although some advisors charge fixed rates) in addition to the costs related to the actual products and/or securities. Investors using full service brokers potentially face additional broker commissions and/or other fees like wrap fees. High net worth and institutional investors tend to have access to lower cost products and services, but may pay additional consulting fees, while those that invest in venture capital, private equity, and hedge funds may face additional performance fees and or additional layers of fees (for instance from funds of funds).

     A useful exercise for investors is to start with theoretical expected returns (usually based on historical returns and current interest rates) and then subtract expected costs. The term "Implementation Shortfall" was coined by Harvard professor Andre Perold. The simple definition is the difference between theoretical paper portfolios and real-money portfolios. Perold and others have also suggested that generally the larger a portfolio is, the harder it is to exploit any informational advantage.

     For an investor, once an asset allocation has been determined, the next step is to invest in specific funds and/or securities. Some investments like government bonds can be purchased with no direct costs, while others like Hedge funds may have multiple layers of costs. Passive investors generally purchase diversified funds, while active investors attempt to improve on index or asset class returns by holding specific securities or subsectors and/or timing those investments.

     On the specific issue of what is the cost to society from active management (relative to passive/index investing), Professor Ken French published an extremely informative paper titled The Cost of Active Investing in the Journal of Finance (August 2008). A one hour presentation is also well worth watching (Presidential Address Video see 2008).

     Using multiple sources of data, French conservatively estimated equity costs resulting from active management (which is a zero-sum/losers game). In the process he also provides some fascinating information about the investment industry and it's evolution over the last few decades. Specifically he looked at costs for both individuals and institutions, by determining mutual fund and hedge fund management fees, and as well as the costs of the trading. The cost differential between active and passive was .67 basis points (the number was surprisingly stable at between 61 and 74 basis points in 24 of the 27 years from 1980 to 2006), which equates to 10% of an assumed 6.7% market return (some believe that return is a high estimate). He did not include tax costs, nor typical investment advisory fees, and some other costs (as well as costs for time spent) that investors often incur. The overall costs by his calculations have been relatively steady, but drops in some categories (mostly from decreasing use of load fees and investors switching to passive investing) have been offset to some extend by increases in hedge fund costs.

     Particularly striking in the study is the turnover information. Annual turnover of US stocks multiplied from 20% in 1975 to 215% in 2007 (284% with ETFs) in 2007. Despite that increase in trading, the total amount investors pay to trade declined from $50 billion in 2000 to $32 billion in 2006. French also supplies estimates of the percentage of investors investing passively. Open-End Mutual Funds went from .8% passive in 1986 to 12.6% in 2006. He estimates that 26% of Public plans were passive in 1986 rising to 52% by 1997. DB, DC and Non-Profits are estimated to be between 29-36% passive as of 2006.

     Other findings included

     French notes that the benefit of active investing is active investors almost certainly improve the accuracy of financial prices, which improves society’s allocation of resources. To the blunt question of why do active investors continue to play a negative sum game, French suggests 1) lack of education about the advantages of passive investing 2) and overconfidence.

     John Bogle takes a broader look at the financial industry in his 2008 book Enough. See Bogle's Presentation, which covers similar material to his Winter 2008 Journal of Portfolio Management article titled A question so important that it should be hard to think about anything else. Bogle estimated society’s cost of investing in 2007 was $528 billion. He points out in the book "No one knows the exact number. All that can be said for certain is that, one way or another, these billions are paid by investors themselves."




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