Yes, annual management fees for actively managed funds are far higher than they are for index funds. But it’s the linked costs of active funds that people don’t consider, and those can be even more significant.
Anyone who uses so-called budget airlines will be familiar with what economists call linked costs, or junk fees as Americans tend to call them. Linked costs are secondary expenses that arise as a result of buying a primary product or service. So, for instance, you may well be able to fly to Majorca for £10, but if you want to come back again, sit by your wife and take a suitcase with you, the total amount you pay will be very much higher (and wait till you see the price of coffee and sandwiches!)
Actively managed funds are laden with linked costs. First there are the actual costs, or the fees and charges investors pay. The fee we tend to focus on is the annual management charge, but that’s only part of what active investors pay. They also incur a number of costs every time the fund manager places a trade, and bear in mind that active managers like to trade. The average portfolio turnover rate for actively managed funds in the UK is typically between 50 and 100 per cent a year. In other words, managers replace between half and all of the fund's holdings within a 12-month period, and it’s you, the customer, who’s footing the bill.
A second linked cost of active funds is underperformance. Of course, the main reason people use an active manager in the first place is to beat the market. The irony is that, over meaningful time periods, the vast majority of active funds are beaten by the market, once those afore-mentioned costs are factored in. The most recent SPIVA data show that around 90% of UK-domiciled funds underperformed their benchmarks over a period of ten years.
The biggest cost of all
However, as Charles Ellis, the financial author and former chair of Yale’s Investment Committee, recently explained in the Financial Times, the biggest linked cost active investors incur stems from behavioural economics.
Active fund investors (and even, to an extent, active fund managers) are prone to behavioural biases and natural human emotions that cause them to act irrationally. It’s very tempting to invest in a stock or a fund that’s delivered strong returns in the recent past, and just as tough to stick with an investment that’s been on a bad run. Consequently, investors tend to buy and sell at the wrong time.
“Since most of us do not keep careful records,” Ellis wrote, “it is hard to realise the extent of this. But by striving to do better, the average equity investor hurts their performance by more than two percentage points in an average year, according to a study by research firm Dalbar of returns over the 30 years to the end of 2023. In an 8 per cent return market, this works out as a 25 per cent share of returns. Most people would agree that this is substantial. And if you are looking at real returns after inflation, the impact is even more.”
Active investors, then, are like holidaymakers who end up paying far more for their fights than they bargained for. Like people who buy a fancy electric toothbrush or an ink-thirsty printer without researching the cost of replacement brushes or cartridges, they risk being stung by the total cost of ownership.
Linked costs vs linked benefits
The good news is that investors have a better alternative. OK, it’s hard to get excited about low-cost index funds, but they come with a range of advantages, or, if you like, linked benefits.
Essentially these benefits are the flipside of the linked costs associated with active funds. First, index trackers are very much cheaper than active funds — typically around 70 or 80 per cent cheaper — and because the annual turnover for index funds is as low as 4 per cent, the transaction costs you incur are also far smaller. Secondly, on average, the performance of index funds is significantly better than that of active funds. But again, the greatest benefit of using trackers is behavioural.
Warren Buffett, the world’s most famous living investor, has used his annual letter to Berkshire Hathaway shareholders to impart wisdom to ordinary investors since 1977. Perhaps his most consistent message is that the less investors do, the better their returns are likely to be. In his 1990 letter, for instance, he described “lethargy bordering on sloth” as the cornerstone of his investing style. The following year he wrote: ”Inactivity strikes us as intelligent behaviour."
Index funds encourage inactivity, which is one of the reasons why Warren Buffett has repeatedly recommended them. When you stop trying to beat the market and simply aim to capture market returns, the inevitable ups and downs of different financial markets and of individual securities become much less important. Of course, index fund investors are not immune from poor decision-making, but it’s certainly less of a problem.
Think before you buy
When you consider these issues rationally, the choice is surely a no-brainer. The behavioural advantage of indexing, combined with lower fees and better performance should be more than enough to dissuade us from using active funds.
The problem is that, for most people, emotions play a bigger part than logic and evidence when choosing funds to invest in. Often they’re swayed by seductive marketing, or they make a decision without giving it enough thought. Whatever their reasons for investing, they end up paying a far bigger price than they expected.
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