Investment "Costs": What A Drag

Have mutual fund managers (as a group) added value to portfolios relative to comparably composed Index Funds? No. The Evidence is clear in this regard. Do fund managers (as a group) incur substantial additional costs in the attempt to add value in excess of returns available from Index Funds? Yes. These additional costs can easily be 2-3% per year (or higher). Note! Click on Costs for a detailed review of these disclosed and undisclosed costs incurred by fund managers in their attempt to add value.

Let's put these increased costs in perspective. Let's examine these costs as a percentage of various possible rates of return from investment. Let's ask: what is the performance DRAG from the high costs engendered by the average fund manager? What percentage of return is absorbed by the high costs of the average equity (stock) mutual fund? The results are truly startling!

For purposes of comparing average fund manager "costs" drag on performance to the "costs" drag of Index Funds, we have, in the chart and graph below, utilized a variety of assumptions. We compared hypothetical funds of similar investment class, one an average equity equity fund and one an Index Fund. We assumed an average 2.5% "costs" drag on the average equity fund versus a .5% "costs" drag on the Index Fund. (Again, see Costs to better understand this huge difference in costs between Index Funds and the average equity mutual fund). We plotted a range of possible gross (pre-cost) performance returns and then calculated the "costs" drag for each the equity fund and the Index Fund as a % of each of the various gross returns.

As reflected in the chart and graph below, at lower gross return levels, the extraordinary costs from investment in the average fund can sap extraordinary percentages of the total investment return. At 4%, more than 60% of performance is lost to costs. Even at 10%, the costs of investment of the average fund can be reasonably expected to sap 25% of total gross performance. If the fund managers added to the gross performance, these costs might somehow be justified. But the Evidence shows that 1) overall, fund managers do not add value and 2) there is little evidence to support any reasonable belief that those managers who have added value in the past will continue to add value in the future (see Fallacy of Persistency elsewhere on this web site.) The benefit of utilizing low cost Index Funds instead of high cost "managed" mutual fund is obvious: the net return should be considerably higher with Index Funds.

The chart and graph also demonstrate one other reality of investment life. In a period of extraordinary high performance returns, fund costs have considerably less percentage impact. In a period of less than historically average returns, the performance drag from costs becomes very meaningful.