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Lower Costs Equals Stronger Performance

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For most individual investors, I believe that a passively managed, well diversified investment portfolio is the best approach for long term success.

I do not believe that paying higher fees for active management brings superior results over the long run. Instead, minimize investment costs and stick to index funds for the majority of investments. Let portfolio returns compound in your investment account, not in the pocket of an investment advisor or financial institution.

I have written extensively as to why I believe in this strategy.

Today, a little more evidence that a passive approach outperforms an active one. 

A Little Bit Technical

Vanguard reviewed data [4] for various funds under two scenarios.

It gets a bit technical, so if you do not need to know the analysis feel free to skip ahead to the results below. And the quotations below come from the actual underlying research document, not the linked summary.

First, Vanguard reviewed a “Morningstar database of the returns of actively managed funds from 1990 through 2010” and “calculated alphas relative to the stock market’s four common risk factors”.

Note that “alpha” is a risk-adjusted return calculation. It represents the ability of the investment manager to add value to the portfolio through active management. The “four common risk factors” are market risk, small market cap minus big (SMB), high book-to-market ratio minus low (HML), momentum risk.

Vanguard then looked at the probability of funds remaining in the top-performing fund quartile over holding periods of 1, 3, 5, and 10 years. The researchers presented two sets of probabilities, one with survivorship bias [5] and one without. The results without survivorship bias are more relevant to investors.

Second, Vanguard examined outperformance of U.S. equity mutual funds by expense ratio quartiles over 5, 10, 15, and 20 year periods ending December 31, 2010.

The researchers reviewed “the relationship between fund alphas and four readily observable fund characteristics”. These being the fund expense ratio, portfolio turnover, fund asset size, and fund age.

Vanguard’s Results

Active Management Does Not Consistently Produce Alpha

In assessing the probability of an actively managed fund remaining in the top performing quartile, Vanguard found that, when you exclude survivorship bias, there is less than a 16% probability of remaining in the top quartile over any of the 1, 3, 5, or 10 year periods.

Very interesting in that in a purely random distribution, there should be 25% of the top quartile performers in the same quartile in future periods.

This suggests that actively managed funds do not outperform their expected returns on a consistent basis.

Also, that while some funds may have achieved outperformance in previous periods, it may not be achievable in future returns.

As such, spending money on higher fees for active management will not result in better portfolio performance over time.

Expenses are Powerful Predictors of Performance

Fund expense ratios and portfolio turnover can significantly reduce potential alpha.

Vanguard found that “for every 1 percentage point increase in expenses, alpha declined by 0.78 percentage point.” As well, “for every 1 percentage point increase in portfolio turnover, alpha declined by 0.22 percentage point”.

As for actual performance, “over the 20-year period, 49% of the funds in the lowest-cost quartile beat the benchmark while a mere 16% of funds in the highest-cost quartile did so. Similar patterns were apparent in shorter time periods.”

As “selecting active managers that consistently outperform their respective benchmarks is such a difficult task, focusing on low-cost index funds is a helpful and valuable quantitative measure.”

My Thoughts

One, I should point out that Vanguard is in the business of offering low-cost index funds. So their researchers may have a vested interest in finding that low-cost index funds is the way to invest. However, the results are consistent with other studies I have encountered.

Two, as I have written before, it is questionable as to whether active management can consistently outperform a passive approach [6] over time. Even if an actively managed fund has outperformed historically, there is a strong probability of underperformance in the future. This Vanguard data supports that contention.

Note as well that this same argument can be applied to investment analysts [7] as well as fund managers. Unless you can jump from hot manager to hot manager (or analyst), keep it simple and invest in index funds.

Three, fund costs take a huge toll on fund performance [8]. The Vanguard indicates that a fund’s expense ratio is a predictor of future performance. When faced with two comparative funds, you are likely better off investing in the lower cost fund.

A large number of exchange traded and open-ended index mutual funds are available for many different markets and indices. Make certain that you compare cost structure [9] in each before investing. There is a good probability that the lower cost fund in a specific market will outperform the higher one over time.