The Quest to
BY LARRY SWEDROE
he debate over whether financial markets are innately efficient rages on. Most academics argue that they are, making active portfolio management a loser’s game where the odds of winning are so low it doesn’t make sense to play. Active portfolio managers can’t accept such an argument because it would put them out of business. Noted economist Paul Samuelson sums it up this way: “A respect for evidence compels me to the hypothesis that most portfolio managers should go out of business. Even if this advice to ‘drop dead’ is good advice, it obviously will not be eagerly followed.”
While the efficient-markets theory makes an interesting debate and provides useful insights into how markets work, investors really need to know the answer to this question: Can active managers consistently make money exploiting market inefficiencies after factoring in the costs of their efforts? Mutual fund managers who have outperformed the market in the past make it seem easy, but identifying future winners is difficult. For the majority of investors, active management has achieved inconsistent and below-market results. Before recommending that clients or employers pursue an active portfolio management strategy, CPAs and other financial managers should understand some of the costs that must be overcome for this approach to outperform the market.
IS ACTIVE MANAGEMENT WORTH IT?
Let’s look first at the overall record of actively managed mutual funds for the 16-year period ending in mid-1998. The annual return of all equity funds that survived the period was 16.5%, or just 87% of the 18.9% return of the Wilshire 5000 index. An index fund with operating expenses of about 0.2% would have provided close to 99% of the returns available from the index it was tracking, including dividends. The difference in returns is actually understated, due both to survivorship bias (poorly performing funds disappeared from the data) and the impact of taxes on fund distributions. The 2.4% underperformance of all equity funds compared with the Wilshire 5000 index fund is caused by the fund’s operating costs.
A study by Mark M. Carhart while he was at the University of Southern California—the most comprehensive ever done on the mutual fund industry—supports this data. After accounting for style factors (small-cap vs. large-cap and value vs. growth), the study found the average actively managed fund experienced annual returns almost 2% lower than those of its appropriate benchmark.
The SEC requires mutual fund prospectuses to provide information investors can use to make educated decisions. The required information includes investment philosophy, expenses and past performance. Expense information is generally limited to the fund’s operating expense ratio and any 12b-1 charges (essentially marketing expenses the fund passes on to investors). Unfortunately, these expenses are just some of the costs active managers impose on investors in their pursuit of the Holy Grail of “outperformance.”
Funds actually incur five types of expenses:
Each of these expense categories creates overhead of 1% or more for active managers to surmount. For tax-deferred accounts, the active-management hurdle is at least 4%.
How much does this cost mutual fund investors in diminished returns? To answer this question, we will look at the total costs of equity funds as well as the implications of another little understood obstacle, closet indexing. In the end, CPAs are likely to share the view that whether or not the markets are efficient is irrelevant. Even if there are inefficiencies that offer opportunities for profit, the cost of trying to exploit them is likely to exceed the benefits of doing so. The only way to win the loser’s game is not to play. Instead, put your money in passively managed funds.
THE OPERATING EXPENSE HURDLE
Operating expenses are highly visible and as such are about the only expense category that receives investor attention. Before making a decision, most investors should consider a fund’s operating expenses. But there are other, hidden expenses that are not reported. Instead, they just show up in reduced investment returns.
The average operating expense for actively managed funds is 1.53%. For the typical domestic index or passive-asset-class fund, expenses are between 0.2% and 0.5%. (International funds, both active and passive, typically have higher expense ratios.) Thus, actively managed funds begin with a cost hurdle of 1% or more that they must clear to add value. This figure does not include any 12b-1 expenses or load fees. If a fund imposes such fees, the amount obviously increases. Active managers might argue that operating expenses such as research add value, but the only thing distribution and advertising fees do is reduce returns.
THE COST OF CASH
Assume the typical actively managed fund maintains an average cash position of about 10%. For the 15 years ending in 1998, the S&P 500 provided total returns of about 18%. During that same period, one-month treasury bills (a good proxy for the return earned on invested cash) yielded about 6%. The cost of cash for actively managed funds is 1.2% per year (18% – 6% x 10%). For a passively managed fund, which is generally 99% invested, the cost of cash is only 0.12%. When added to operating expenses, the value-added bar has now been raised to more than 2%.
HIDDEN TRADING EXPENSES
Trading expenses are another hidden cost. The average actively managed fund has turnover of about 80%. Trading costs (commissions and bid/offer spreads) are about 1% to buy and 1% to sell (or 1% x 2). Large-cap stock spreads are somewhat narrower; small-cap stock spreads much wider. The result is the average actively managed fund incurs trading costs of about 1.6% [(1% x 2) 3 80%]. Depending on the index it is attempting to replicate, the typical passively managed fund has turnover of between 3% and 25% (lower for passive large-cap funds and higher for passive small-cap funds). If we assume an average turnover of about 15%, we can estimate the cost of trading at 0.3% (1% x 2 x .15). For active managers, the breakeven for trading costs is therefore 1.3% (1.6% – 0.3%).
A Morningstar study supports the conclusion that high turnover erodes profit. Morningstar divided mutual funds into two categories: those with an average holding period greater than five years (less than 20% turnover) and those with an average holding period of less than one year (turnover greater than 100%). Over 10 years, Morningstar found that low turnover funds rose an average of 12.87% per year; high turnover funds gained only 11.29% on average. Trading activity reduced returns of high-turnover funds by 1.58% per year.
The inclusion of trading costs increases the expense hurdle an active manager must overcome to over 3% (more than 1% each for operating expenses, cost of cash and trading costs). For actively managed international funds commissions, custodial fees and operating and trading cost differences are even greater than for domestic funds. Bid/offer spreads generally are higher, too. Costs such as stamp duties, which do not exist in the United States, also must be considered.
MARKET IMPACT COSTS
Unfortunately, trading costs do not end with commissions and bid/offer spreads. Active managers incur market-impact costs, too. Market impact is what happens when a mutual fund buys or sells a large block of stock. The fund’s purchase or sale causes the stock to move beyond its current bid (lower) or offer (higher) price, increasing the cost of trading.
BARRA Inc., a Berkeley, California–based research organization ( www.barra.com ) studied market-impact costs and found many factors (fund size, asset class and turnover) can influence costs. BARRA noted that a typical small-cap or mid-cap stock fund with $500 million in assets and an annual turnover rate of between 80% and 100% could lose 3% to 5% annually to market-impact costs—far more than the annual expenses of most funds.
For the period BARRA studied, the PBHG Emerging Growth Fund happened to have the highest estimated market-impact cost among small-cap or mid-cap funds—5.73% annually. Even large-cap funds can have large market-impact costs. BARRA estimated the Phoenix Engemann Aggressive Growth Fund’s market-impact cost at 8.13%. Using even the most conservative estimates, market-impact costs can be assumed to add at least another 1% to the costs active managers must “beat” to achieve above market returns, raising the total so far to at least 4% per year.
THE PROBLEM WITH TAXES
Unfortunately for investors, taxes on fund distributions are the biggest expense they face. Although taxes may be minimal in any one year, over a protracted time period they can add up.
A study, commissioned by Charles Schwab and conducted by John Shoven, a Stanford University economics professor, and Joel Dickson, a Stanford PhD candidate, measured the performance of 62 equity funds for the 30-year period from 1963 through 1992. It found that although each dollar invested in this group of funds would have grown to $21.89 in a tax-deferred account, the same amount of money invested in a taxable account would have produced only $9.87 for a high-tax-bracket investor. Taxes cut returns by 57.5%.
A simulated study, by James Garland of Jeffrey Co. in Columbus, Ohio, covered the 25-year period ending in 1995 and examined the effects of expenses and taxes on investor returns. (A simulated study analyzes hypothetical rather than actual performance results.) The study—in the Spring 1997 Journal of Investing —assumed a hypothetical mutual fund that
The Garland results found that the typical investor received only 41% of the preexpense, pretax returns of the index. The government took 47%, a figure that would have been even higher had state and local taxes been considered or had the investor been subject to the highest tax brackets. The fund manager received 12% of the pretax, preexpense returns. This study also found that reducing operating expenses to 0.3% would have raised the investor’s share of returns to only 45%, from 41%.
The investment horizon doesn’t have to span 25 to 30 years to reveal the negative impact of taxes. Robert Jeffrey of Jeffrey Co. and Robert Arnott of First Quadrant in Pasadena, California studied the performance of 72 actively managed funds for the 10 years from 1982 through 1991. Although 15 of the 72 funds beat a passively managed fund on a pretax basis, only 5 did so after taxes.
Morningstar studied the five-year period 1992 through 1996 and found that diversified U.S. stock funds gained an average of 91.9%. Morningstar then assumed that income and short-term gains were taxed at 39.6% and long-term capital gains at 28%. The result was that aftertax returns dwindled to 71.5%, a loss of 23% in just five years. A more recent study covering the five-year period ending June 1998 found that the average actively managed fund lost 21% of its pretax return to taxes compared with just 9% for an S&P 500 index fund.
Tax-managed funds. Investors now have available to them a wide range of passively managed asset-class or index funds that are also tax-managed. The passive strategy these funds follow keeps turnover and taxes low. Tax-managed funds strive to both minimize fund distributions and maximize the percentages of distributions that will be in the form of tax-favored long-term capital gains. The funds accomplish this by implementing these strategies:
A number of fund families, including Dimensional Fund Advisors, NationsBank, Charles Schwab and the Vanguard Group, have created passively managed funds that are also tax-managed. A study by KPMG, Tax-Managed Mutual Funds and the Taxable Investor, found that after 20 years, a $10,000 investment in a tax-managed fund would be 25% greater than a comparable investment in an actively managed fund. Taxes cost the tax-managed fund 11% of its pretax returns, compared to 23% for the actively managed fund.
A WOLF IN SHEEP’S CLOTHING
A closet index fund is one that looks like an actively managed fund (a wolf), but because the stocks it owns closely resemble the holdings of an index fund (a sheep), investors pay large fees for only minimal differences. The amount of differentiation from an index fund can be measured by a fund’s correlation to its benchmark index. The higher the correlation, the less the differentiation. For example, a fund with a correlation of .95 would experience 95% of the S&P 500’s advances and declines.
Assume an actively managed fund has operating expenses of 1.2%, or 1 percentage point higher than a similar index fund. The average actively managed fund has a correlation to the S&P 500 (in this example) of more than 86%. With a $100,000 portfolio, an investor really has $86,000 in an S&P 500 fund and $14,000 in a differentiated portfolio. He or she is paying $1,200 in fees, just 0.2% of which—or $172—is on the $86,000 in an index fund. The investor pays $1,028 in fees on $14,000 of assets, a fee of over 7%. This is a substantial expense an active manager must overcome to outperform.
The larger a fund the more diversified it generally becomes. The more a fund diversifies the higher its correlation to its index. Overcoming a high correlation is difficult. For the three years ending August 31, 1999, the five largest funds with correlations of over 95% returned between 21% and 26.9%. After taxes, an investor would have received between 18% and 24.6%. Vanguard’s S&P 500 Index Fund beat them all. It returned 28.5% pretax and 27.5% aftertax. Of the 80 largest funds with correlations over 95%, only 3 managed to beat the Vanguard index fund and just barely did so. None did so after taxes.
JUMPING THE HURDLE
Instead of being concerned about whether the markets are efficient, investors should be advised on whether active managers add value in excess of the costs of their efforts. The Carhart mutual fund study found that the average actively managed fund underperformed its benchmark on a pretax basis by almost 2% per year. Although it appears active managers were able to exploit market inefficiencies to some degree, since they underperformed their benchmarks anyway they would have been better off had they never pursued the Holy Grail of outperformance in the first place.
Given their poor performance, how do actively managed funds get away with charging high fees and incurring large costs? It’s simple: Investors let them. Investors aren’t focused on costs, partly because the markets have done so well in recent years. In addition, investors don’t receive a bill labeled management fee or trading costs—the fees are deducted from the fund’s total assets and never show up on an account statement.
Informed investors know their objective is to achieve the greatest percentage of available returns on the asset classes in which they invest. Wall Street doesn’t want investors to know that the easiest way to achieve that objective is to minimize all fund expenses—not only operating expenses, but trading costs, market impact costs, the cost of cash and taxes as well. An investor who knows this would stop paying a 1.5% management fee for a poorly performing actively managed fund and would instead pay much lower fees for tax-efficient passively managed funds.
Vanguard’s George Sauter perhaps said it best: “When you layer on big fees and high turnover, you’re really starting in a deep hole, one that most managers can’t dig their way out of. Costs really do matter.” Taxes matter, too. The winner’s strategy CPAs and other financial managers should recommend to their clients and employers is to use index and other passive funds. For taxable accounts, use passive funds that are also tax managed.