Monday, March 10, 2008

What is the cost to beat the market?

Every investor wants to beat the market. Many are willing to spend quite a bit extra in fees, expenses, commissions, and other costs in an attempt to squeeze excess alpha out of Wall Street.

A study, “The Cost of Active Investing”, by Kenneth French, of Fama-French fame, has drawn attention to the price paid by average investors as they attempt to beat the market. What is the total cost? Currently, investors spend for than $100B per year attempting to exceed the returns of a standard low-expense index fund.

A recent NYT article outlined the highlights of the study and associated conclusions. Over time the portion of stocks’ aggregate market capitalization spent on trying to beat the market has stayed near 0.67 percent, demonstrating that the financial industry has continued to find ways to fleece investors over time. Even in a changing environment of reduced transactions costs, reduced sales charges, narrowing spreads, and other beneficial factors – the brokerage firms have found new ways to stick it to normal investors.

Sadly, most actively-managed mutual funds fail to beat the market over time. So in one sense, despite the excess costs burdening investors, non-passive investing normally fails to deliver on the promise to wring alpha out of the market for the average investor.

What is the bottom line? Most average investors would be better off placing their money in low-expense index funds. The fees, loads, and commissions charged by actively managed mutual funds rob investors of more than they gain from the active management over time. It is more important for most investors to think about low-expenses than out-performing the market when creating their diversified portfolio.

One other conclusion not touched on in the article is that only active investors who pay close daily attention to the markets are normally successful in squeezing out excess alpha. Most invest directly in stocks and ETFs rather than mutual funds in order to beat the returns offered by index funds. As a whole, these active investors are more successful than most fund managers over time. Typically these information savvy “power investors” focus on value or momentum for their investment decisions, and utilize advanced computer screening tools that enable them to succeed.