Mutual fund expenses may be making you poorer. Investing in actively-managed mutual funds that charge high fees can lower your standard of living in retirement by as much as one-third over a low-cost index fund strategy. This is the conclusion of Nobel Laureate William Sharpe in his latest Financial Analysts Journal article The Arithmetic of Investment Expenses.
When I first read Sharpe’s article on why high fund fees can shrink the size of a retirement portfolio by about one-third, my first thought was “Well, duh? Of course they do!” Then I recalled my own rule about articles that explore the benefits of low-cost index fund investing — the truth about index funds must be repeated over and over again because myths about the superiority of active management are constantly being told. All articles are worthy, regardless of the angle used to deliver the message.
The Arithmetic of Investment Expenses explores the benefits of index funds in a way that should resonate with the public. Sharpe states that people who invest in index funds are very likely to accumulate more money than those who buy higher cost actively-managed funds. Actually, he says it the other way around. An investor will have less money if they buy actively-managed funds than if they stick with index funds. I think this is a good approach because the fear of having less money is more powerful than the prospect of having more.
Sharpe’s article is about arithmetic, so there’s naturally a lot of math in the text. You can skip it. The logic of the argument speaks for itself.
First, actively-managed mutual funds cannot earn excess returns over index funds because in aggregate they earn the same as index funds, less the difference in cost. This assumption was proposed by Sharpe in his timeless 1991 article, The Arithmetic of Active Management. “Properly measured, the average actively-managed dollar must underperform the average passively-managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
Second, he documents the expenses of active funds and index funds in the marketplace. Using Morningstar data, Sharpe found the average actively-managed U.S. stock fund had an expense ratio of 1.12 percent during 2012. The Vanguard Total Stock Market Admiral Shares (VTSAX) with an expense ratio of 0.06 percent was selected as his market index fund proxy.
Third, Sharpe uses a bunch of math to compute portfolio terminal values and probabilities using various scenarios going out several decades. He then compared the results of accounts that invested in actively-managed funds to an account that invests only in VTSAX.
Sharpe’s conclusion echoes that of many academics and authors as well reinforces his own previous work, “the odds are even that an investor in the low-cost fund will be well over a third richer than an investor in the high cost fund after 30 years. But there is a small chance that an investor in the low-cost fund will regret not having selected the high-cost fund. For those who choose funds with high expense ratios, hope may spring eternal.”
While I didn’t find The Arithmetic of Investment Expenses to be particularly revealing, I do believe its influence will be widespread because William Sharpe wrote it. This alone warranted the attention of the prestigious Financial Analysts Journal and several media mentions.
Would this article have received national attention if someone of less stature wrote it, like me perhaps? We’ll never know, and it doesn’t matter. What matters is that once again the truth about high mutual fund fees is being exposed and the benefit of index investing is being propagated. Thank you, Dr. Sharpe, for all you have done to help investors lower costs and increase returns.
