You read that right: The fees are too *** high and they have cost investors over $250 billion since the year 2000. I am talking about fees charged by actively managed mutual funds in comparison to their passive fund counterparts. To examine this, let’s begin with the motivation for this inquiry. Over the weekend Warren Buffett released his annual shareholder letter for Berkshire Hathaway in which he stated:
“My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up.”
Buffett was referring to hedge funds, of which he is an outspoken critic. However, I decided to test this calculation using data on U.S. equity funds from the 2016 Investment Company Factbook (found here). The idea to test this is simple: Look at the amount of additional fees that active funds charge as compared to index funds/ETFs and multiply this by the amount of money that could have been in index funds/ETFs over this time period.
From the year 2000 to 2015 you can see that active equity funds have charged between 70–80 basis points more than equity index funds/ETFs (from the 2016 Investment Company Factbook):
The additional fees that the active equity funds charge represent the solid blue line minus the solid yellow line. This is simple enough.
As for the “amount of capital that could have been in index funds/ETFs over this time period” I have to make an assumption. That assumption is that roughly 75% of U.S. equity fund capital can be in passive funds before the market begins to get inefficient. Since passive funds do not pick individual stocks, but invest in a broad basket such as the S&P 500, they can not keep markets efficient. This means that the market requires some active managers to keep prices in check by “looking” at individual stocks to see which ones are over priced and which ones are under priced. Jack Bogle, the founder of Vanguard and champion of index investing, thinks markets would not get inefficient until passive funds represented 90% of the fund market, so 75% is a conservative estimate.
With this assumption, the total overcharge by active funds (70–80 basis points * amount of capital in active funds that could be in passive funds) from 2000–2015 is roughly $280 billion:
To give you an example calculation, in 2015 active funds had $4.559 trillion in capital while passive funds had $2.719 trillion. With my assumption that 75% of all fund money could be passive, this means that there should have been 25% of total capital ($1.8 trillion) in active funds. However, there was ~$4.6 trillion, or an additional $2.8 trillion, in active funds that was being overcharged. $2.8 trillion multiplied by the active fund additional fee of 0.73% = $20 billion.
Active mutual funds, on average, are overcharging investors between $10 and $20 billion each year! I say overcharging because the active funds, on average, will have the same performance as the passive funds before fees (this logic is explained by William Sharpe here). Some active funds are winners that beat the market and some are losers that underperform, but they collectively represent the market return.
I know it is not easy to conceptualize what $20 billion can buy, but here is a simple comparison: the NFL revenues in 2016 were roughly $13 billion. This means that active U.S. equity funds are bringing in more unnecessary annual revenue than the NFL despite providing no additional value for this revenue.
I also want to point out that my estimates are conservative because they do not include non-U.S. equity, bonds, or any other market where active funds could be overcharging their investors. I did this purposefully as some argue that non-U.S. equity/bond markets are less efficient and the active managers in these markets actually earn their fees.
So was Warren Buffett right? Yes he was, but his $100 billion estimate was conservative, as he stated in his letter.
What to Do About the Fees
Despite the overcharges of the past, investors are waking up and voting with their dollars. Last year there were record inflows into low cost passive funds and I expect this trend to continue. However, I am surprised at how long it has taken to get to ~33% passive share of the market. I would have expected that passive funds would be over 50% of the market by now.
Then again, it is either investor ignorance or the hope of beating the market that prevents passive funds from capturing more market share. I am guessing that the hope of beating the market is the stronger effect. People have always believed that someone could predict the future, whether that means looking into a sheep’s liver or picking stocks. For your financial sake, I hope you are not one of these people. Remember to keep your fees low and thank you for reading!
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This is post 11. This post does not have any code, but my programs for other posts are here: https://github.com/nmaggiulli/of-dollars-and-data