I recently ran across an interesting article by Burton Malkiel in The Journal of Economic Perspectives. In it, he examined the growth of the financial services industry since 1980.
Care to guess what he learned?
Well, for starters… As a fraction of the GDP, the size of the financial services sector increased by ca. 70% (from 4.9% of GDP to 8.3% of GDP). Not only that, but this growth has been driven in part by a substantial increase in asset management fees.
The cost of management
Looking at the data, expense ratios rose from 66.0 basis points (bp), or 0.66%, to 69.2 bp in 2010. That doesn’t sound too bad, does it? Well, consider that during that same period there has been an overall shift toward low-cost index funds.
Back in 1980, the share of equity funds under active management stood at 99.7%. In 2010, that number had declined to 70.9%. Since index funds tend to have very low expense ratios, this shift is masking a dramatic increase in the cost of active mutual fund management.
If we exclude index funds and ETFs and recalculate expense ratios, the numbers look very different. Indeed, the costs associated with active management back in 1980 stood at 66.1 bp. In 2010, the average cost of active management was 37% higher at 90.9 bp.
Thus, during a time when more Americans were investing and financial managers should have been able to realize economies of scale, thereby driving prices down, the opposite happened in the world of active management.
Getting what you pay for?
That’s no big deal, though. Right? After all, investors are likely to be getting better performance in return for their higher fees. Right?!?!?
As it turns out, there’s no evidence that this is true. According to Malkiel:
“The data consistently provide overwhelming support for low-cost indexing as an optimal strategy for individual investors.
Over longer periods of time, about two-thirds of active managers are outperformed by the benchmark indexes, and the one-third that might outperform the passive index in one period are generally not the same in the next period.”
In fact, in an earlier study, Malkiel showed that what little persistence there is in mutual fund returns reflects the fact that costly funds exhibit somewhat consistent underperformance of the relevant benchmarks.
Interestingly, while many active managers argue that they are able to exploit inefficiencies associated with emerging markets and smaller domestic companies, it was precisely these sorts of funds that were the most consistent under performers.
Why pay more?
This all begs the question of why these price increases have been tolerated. Malkiel offers some suggestions. They include the possibility that:
- investors may be judging the quality of the advice they’re receiving by the size of the price tag attached to it;
- advertising campaigns may have convinced people that they need help managing their money and, by extension, that active management is the best approach; and
- investors tend to be overconfident in their ability to choose winning stocks, and this may extend to the selection of “winning” managers.
Whatever the explanation, my personal view is that investors are (on average) doing themselves a huge disservice when opting for active over passive management.