Figure 1: Impact of costs on returns
Half of all invested assets will outperform the market return before costs. After costs, a much smaller portion outperforms the market return.
The indexing concept makes no judgment as to market efficiency, size, or style, nor does it need efficient markets to be effective: Every market will always have an average return, whether the market is deemed efficient or otherwise. Indexing works because
whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur
Active investors in strategies are exposed to commissions, management fees, bid-ask spreads, administrative costs, taxes, liquidity constraints, and other costs. In 2008, French in “The Cost of Active Investing” analysed the total cost to investors who have hired active managers to be more than $100 billion:
Professor French notes that while the total cost of trying to beat the market has grown over the years, the percentage of individuals who bear this cost has declined — precisely because of the growing popularity of index funds.
From 1986 to 2006, according to his calculations, the proportion of the aggregate market cap that is invested in index funds more than doubled, to 17.9 percent. As a result, the negative-sum game played by active investors has grown ever more negative.
The bottom line is this: The best course for the average investor is to buy and hold an index fund for the long term. Even if you think you have compelling reasons to believe a particular trade could beat the market, the odds are still probably against you.
Figure 2: Percentage of active funds underperforming low-cost index funds, For the ten years ended December 31, 2013
HT: vanguard.com
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