Mutual fund management costs 7% per annum!

[DanS]

I'm sure many here have heard of this paper, but it's worth bringing up nonetheless. In short, the expenses of an actively managed mutual fund are normally about 1% per annum while index funds charge about 0.3% per annum. However, the returns for most actively managed mutual funds track index funds rather closely, and therefore should require little active management. Ross Miller at SUNY calculates that managing that portion of the fund's portfolio that actually benefits from active management costs 7% of that portion.

In other words, actively managed mutual funds (i.e., what most of us invest in) are very incredibly expensive when index funds are available to us (my 401k does not offer them, unfortunately). We would be much further ahead just investing most of what we have in index funds.

A corrollary is that while a hedge fund may charge a high percentage in administrative fees in order to manage its investments, the hedge fund does not track the returns of an index fund and therefore is less expensive per unit actively managed. In short, we would do better to invest most of what we have in index funds and a small portion in hedge funds than to invest it all in an actively managed mutual fund.

A corrollary to the corrollary is that the recent huge growth in use of hedge funds is both rational and less risky than our previous setup of actively managed mutual funds.

Quite interesting!

http://econwpa.wustl.edu/eps/fin/papers/0506/0506010.pdf

[JohnT]

In other words, actively managed mutual funds (i.e., what most of us invest in) are very incredibly expensive when index funds are available to us (my 401k does not offer them, unfortunately). We would be much further ahead just investing most of what we have in index funds.

Well, yeah. That's what I've been saying here for years. Not only that, but over 95% of all managed funds underperform the market over a 15-year period, a percentage that goes over 99% when you remove survivorship bias. I mean, there is a reason why they don't have "life of the fund ROR" or "20+ year ROR" in any fund prospectuses.

[JohnT]

And the reason why your 401(k) doesn't offer indexed funds is...?

Because they want the fees.

[DanS]

I don't know if my employer is getting a kickback. If not, then I don't think my employer gains anything by not offering the funds. I'm pretty sure that if my employer insisted on index funds, we would get index funds.

[JohnT]

No, not your employer but the plan provider (the company that actually manages your 401(k)) wants the fees. They can't make any money by offering index funds, so they don't.

And if your employer can get the plan managers to offer index funds, more power to them. But you'll get a lot of resistance, some overt, some passive.

"Did you look into the index funds that I provided you?"
"Not yet - I've been too busy."
"But I gave the list to you three months ago!"
"Yeah, well, let me get right on it."

[DanS]

No doubt. No doubt.

[JohnT]

You could do worse than to get a copy of William Bernsteins The Four Pillars of Investing for some good, yet understandable to the layman, mathematical analysis of the mutual fund industry and their "success."

[pchang]

I have been a Vanguard Voyager customer for almost a decade now. You are a real financial weenie if you know what that means.

[SpencerH]

I liked the piece done by cramer a few weeks ago that clearly indicated that the best way to invest money with mutual funds was to buy the fund stocks themselves not to let them manage your money. They are in the business of making money for themselves. They are not in the business of making money for you.

[DanS]

As I understand it, Bernstein recommends against any investing in individual stocks. As I have stated previously, I think taking a small portion of your portfolio and investing in individual stocks (or a startup or whatever) is a good move, if you are willing to spend the time in research or effort in managing a small business. This would be similar to the utility of a hedge fund.

[JohnT]

Btw, the only managed fund I have in my portfolio is Dodge and Cox Balanced. The rest are Vanguard index funds.

[JohnT]

Originally posted by DanS
As I understand it, Bernstein recommends against any investing in individual stocks. As I have stated previously, I think taking a small portion of your portfolio and investing in individual stocks (or a startup or whatever) is a good move, if you are willing to spend the time in research or effort in managing a small business. This would be similar to the utility of a hedge fund.

Note that Bernsteins book is for the average investor, not the sort of person who enjoys tearing into a 10-K.

[DanS]

OK. Yeh, I do enjoy tearing into a 10-K.

[JohnT]

10:1 says that over 50% of today's investors in the stock market have no idea what a 10-K is.

[SpencerH]

It's a road race.